What Is IRC 529 and How Do Qualified Tuition Programs Work?

Saving for education can be challenging, but 529 plans offer a tax-advantaged way to set aside money for future schooling costs. These accounts help families grow their savings while benefiting from tax breaks at both the federal and state levels.

Understanding how these plans work is key to maximizing their benefits. From account ownership to qualified expenses, several factors determine their effectiveness.

Ownership Basics

The account owner controls a 529 plan, making all decisions about contributions, investments, and withdrawals. This is typically a parent or grandparent, but any individual or certain legal entities, such as trusts, can own an account. Unlike custodial accounts under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA), ownership does not automatically transfer to the beneficiary upon reaching adulthood. The account owner retains control unless they choose to transfer it.

A key advantage of 529 plans is the ability to change beneficiaries. If the original beneficiary does not pursue higher education, the account owner can designate a new beneficiary, provided they are a qualifying family member under IRS rules. Eligible relatives include siblings, parents, first cousins, and even the account owner. This flexibility helps families avoid unnecessary withdrawals that could trigger taxes and penalties.

529 plans also impact financial aid calculations. If a parent owns the account, assets are assessed at a maximum rate of 5.64% when determining the Expected Family Contribution (EFC) for federal student aid. Previously, distributions from grandparent-owned accounts were treated as untaxed student income, which could significantly reduce aid eligibility. However, changes to the Free Application for Federal Student Aid (FAFSA) starting with the 2024-25 academic year have eliminated this penalty, making grandparent-owned accounts more appealing.

Contribution Limits

529 plans allow for substantial contributions but must comply with federal gift tax rules. In 2024, individuals can contribute up to $18,000 per beneficiary without triggering the gift tax. Married couples who elect to split gifts can contribute up to $36,000 per beneficiary without tax consequences.

A unique feature of these plans is the ability to “superfund” contributions. Individuals can contribute up to five times the annual exclusion—$90,000 for individuals or $180,000 for couples—in a single year and treat it as if it were spread over five years for tax purposes. This strategy helps maximize education savings while minimizing estate tax exposure.

Each state sets its own maximum aggregate balance for 529 accounts, typically ranging from $235,000 to over $550,000. Once an account reaches the state’s cap, additional contributions are prohibited, though earnings can continue to grow. These limits align with the estimated cost of higher education, including tuition, fees, and related expenses.

Qualified Education Costs

To maintain tax-free status, 529 funds must be used for qualified education expenses. Tuition and mandatory fees for college, university, vocational school, or other eligible postsecondary institutions are covered, provided the school participates in federal student aid programs. Books, supplies, and required equipment also qualify. If a course mandates specific software or tools, those costs can be paid with 529 funds.

Room and board expenses are eligible if the student is enrolled at least half-time. The tax-free withdrawal amount is limited to either the actual cost of housing or the school’s published cost of attendance for room and board, whichever is lower. Students living off-campus can use 529 funds for rent and food, provided they do not exceed the school’s estimated housing allowance.

Recent changes have expanded qualified expenses. Up to $10,000 per year can be used for K-12 tuition at private or religious schools. Additionally, a lifetime limit of $10,000 per beneficiary can be applied toward student loan repayments, including those of the beneficiary’s siblings. Apprenticeship programs registered with the U.S. Department of Labor are also covered, allowing funds to be used for tools and equipment necessary for training.

Distribution Procedures

529 plan withdrawals must be carefully timed and documented to remain tax-free. Funds must be disbursed in the same calendar year the educational expenses are incurred. A withdrawal made in December for tuition paid in January of the following year could result in taxable income and penalties. To avoid this, distributions should match the timing of eligible costs, with receipts and school billing statements kept as supporting documentation.

Payments can be sent directly to the educational institution, reimbursed to the account owner, or transferred to the beneficiary. Direct payments simplify record-keeping and reduce audit risk, but some families prefer reimbursement for flexibility. Regardless of the method, distributions should be tracked to ensure they do not exceed qualified expenses, as any excess is subject to income tax on earnings and a 10% penalty.

If a beneficiary receives a scholarship, a tax-free withdrawal can be made up to the scholarship amount. However, earnings on that portion will be subject to income tax, though the 10% penalty is waived. If a student withdraws from school or incurs unexpected non-qualified expenses, returning funds to the 529 within 60 days may allow for reclassification as a rollover, preventing unintended tax consequences.

Tax Reporting

The tax treatment of 529 plan distributions depends on whether withdrawals are used for qualified expenses. Contributions are made with after-tax dollars and are not deductible at the federal level, but earnings grow tax-free and remain untaxed if used for eligible costs. If funds are withdrawn for non-qualified purposes, the earnings portion is subject to federal income tax and a 10% penalty. Some states may impose additional penalties or require recapture of previously claimed deductions.

IRS Form 1099-Q is issued to the recipient of a distribution, whether the account owner or the beneficiary. The form details the total amount withdrawn, the portion attributable to earnings, and the portion representing original contributions. If the beneficiary receives the funds and they are used for qualified expenses, no tax reporting is required. If a non-qualified withdrawal occurs, the recipient must report the taxable earnings on their federal return, typically on Form 1040.

To minimize tax liability, account owners should ensure withdrawals align with eligible costs and maintain documentation, such as tuition invoices and receipts, to substantiate their tax-free status.