This 529 Plan Mistake Could Cost You Big at Tax Time

More people than ever are using 529 plans to save for college. By the end of 2021, there were 15.7 million 529 savings accounts holding $480.3 billion, according to the College Savings Plan Network. While these tax-advantaged accounts are effective tools for meeting future education needs, a recent analysis conducted by JPMorgan Chase found that overfunding a 529 plan can result in a large tax bill if money remains in the account after the beneficiary has graduated.

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What Is a 529 Plan and How Does It Work?

A 529 plan is a special education savings account dedicated to paying for future college expenses. Under Section 529 of the Internal Revenue Code, money that's contributed to a 529 plan can be invested in mutual funds and similar securities, and then grow on a tax-deferred basis. That money can later be withdrawn tax free if it's used to pay for qualified higher education expenses, like tuition, room and board, books, computers and other needs. However, withdrawals for non-qualified expenses will incur a 10% penalty on top of income taxes.

But money saved in a 529 plan is not limited to college. Up to $10,000 can be withdrawn each year to pay for qualified K-12 education expenses. And with the passage of the SECURE Act in 2019, 529 plan beneficiaries and their siblings can now take up to $10,000 worth of tax-free withdrawals each year to repay student loan debt.

All 50 states, plus the District of Columbia, administer their own 529 plans. Even if you don't live in a particular state, you can still contribute to its plan and then use the money to pay for education in another state.

529 Plan Contribution Limits

While there's technically no annual limit on how much a person can contribute to a 529 plan, contributions that exceed the annual gift tax exclusion ($16,000 in 2022)  will count against a person's lifetime gift tax exemption ($12.06 million in 2022).

However, families also have an option known as "superfunding," which enables them to make five years' worth of contributions at once, all while adhering to the annual gift tax exemption.

For example, superfunding a 529 plan in 2022 would mean contributing $80,000 ($160,000 for couples). Doing so will accelerate potential compound interest and allow the account balance to grow faster. The IRS treats the contribution as if it were made over the course of five years so the large, front-loaded deposit does not exceed the annual gift tax limit.

Don't Make This Mistake With a 529 Plan

The benefits of saving with a 529 plan and using superfunding to do so are well established. But the JPMorgan Chase study shows that 529 plans are most tax-efficient when balances are depleted by the time a beneficiary finishes their education. While leftover funds can be transferred to relatives in the same generation, 529 plans lose some of their tax efficiency when they're used to create educational nest eggs across multiple generations, JPMorgan Chase concluded.

The financial services firm examined what would happen if a hypothetical saver named Tom superfunded his daughter's 529 plan with five times the annual exclusion limit in 1997, 2002, 2007, 2012 and 2017.

Even after his daughter finished college, her 529 account had a whopping $346,805 left over. As a result, Tom must choose what to do with the money. The study assumed Tom did not have the option to name a new beneficiary who is in the same generation as his daughter. Instead, Tom must take a distribution himself and face a hefty tax bill or distribute the whole account balance to his daughter, Jane, who is likely in a lower tax bracket.

A third option is to name a new beneficiary in a lower generation. "The problem with this approach is that proposed regulations would consider this change a gift by Jane of the account balance (not just the earnings) to the new beneficiary," the study explains. "As such, it would consume some of Jane's lifetime gift-tax exclusion (currently, $12.06 million)-although the impact of the gift would be ameliorated by Jane's use of her $16,000 annual exclusion. Our analysis shows this is economically among the least-attractive alternatives."

Instead of superfunding Jane's 529 plan, JPMorgan Chase found that a "pay-as-you-go" method may be more advantageous, as it won't result in a massive leftover balance that's subject to income tax and a 10% penalty. Since Tom is in the highest tax bracket, he would pay a 37% tax on the distribution plus the penalty, reducing the balance to $215,019.

If he used the pay-as-you-go approach, he would have saved nearly $55,000 in taxes after Jane is done with school. Then again, as JPMorgan Chase points out, this method carries inherent risks, including not having enough money to pay for college when the time comes and potentially no longer being alive.

"If a significant balance remains when a student's education is completed (as in our example): After factoring in the taxes and penalties due after a distribution to either Tom or Jane, or after naming Jane's child as a beneficiary, the pay-as-you go method is actually the most tax-efficient approach," the study concludes.

Bottom Line

529 plans are powerful savings tools that allow parents and grandparents to save for the education of their children and grandchildren in a tax-efficient manner. However, high earners in high tax brackets can make the mistake of overfunding a 529 plan, which can result in a large leftover balance and a hefty tax bill. A JPMorgan Chase analysis found that a pay-as-you-go option may be more attractive for high earners, provided they're comfortable with certain risks associated with this strategy.

Tips for Saving with a 529 Plan

• With so many 529 plans to choose from, a financial advisor can help you pick a plan that suits your needs and financial situation. Finding a qualified financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

• When selecting a 529 plan, be sure to look outside of your home state's plan(s). To help you see what's out there, SmartAsset has compiled information on a majority of states' plans. Use our map to navigate between individual states and the plans they offer.

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