By Noah Styles, CPA
Jason is an expert welder. Matthew is the plumber you need to call. You need a CPA like Hannah. What do these people have in common? They all are educated professionals in their respective fields. If there is a child or grandbaby in your life that has college or trade school on the horizon there is a tax-incentivized account worth considering.
Most Americans, anytime the word tax savings is thrown out by a Certified Public Accountant (CPA), everyone in the room draws a collective bated breath to see what is on the table when it comes to tax breaks. Exhale, the tax-favored account we will look at today is the 529 Plan. It falls under the IRS header of Qualified Tuition Programs (QTPs). Originally passed as part of the Small Business Job Protection Act of 1996, 529 Plans are named after section 529 of the Internal Revenue Code. Prepaid tuition programs and Contribution programs are the two types of 529 Plans. We will focus on contribution programs, as they are much more flexible.
In the following paragraphs, we will uncover the benefits of a 529 Plan. We will do this from two perspectives: first, we will slide our Federal tax eyeglasses on our nose and see what the 529 Plan looks like, and second, we will remove our Federal tax spectacles and place them on the table, and pick up our Arkansas tax glasses to see what benefits are reaped on the state level. In 7 minutes hence, you will be the 529 experts in your family. More importantly, you will know if a 529 Plan makes sense for your family. We will use the Smith family for examples throughout this article. The Smith family is comprised of Josiah and Abigail, who have three kids Hannah, Jason, and Matthew. Josiah’s parents are Mr. and Mrs. Smith, and Abigail’s parents are Mr. and Mrs. Johnson.
Federal Tax Perspective
From the 10,000 foot perspective, a 529 account is essentially an investment account that uses post-tax dollars, grows tax-free, and is withdrawn tax-free, if used for Qualified Higher Education Expenses. When you hear “post-tax” dollars, think cash already in your pocket, or money in your checking account. These monies have already been taxed, thus the term “post-tax”. There is no AGI limit on the person contributing to the 529 account. For example, if Grandpa and Grandma Johnson made $270,002 a year, they would be eligible to contribute to the 529 Plan. Wondering where the $270,002 a year came from? In 2019, the US Census Bureau deemed $270,002 per year as the threshold for the top 5% of household incomes in America. Also, there is no maximum contribution per year. Listen, did you hear that? That is the sound of tax savings! Of note, contributions are subject to gift tax rules. So, if Abigail’s parents don’t want to complete a gift tax return for 2021, they should limit the amount of the gift to $30,000 ($15,000 from Grandfather Johnson, and $15,000 from Grandmother Johnson) to Hannah, Jason, and Matthew for a total of $90,000. There is a maximum on the Federal level on the total amount in the account. The definition is “can’t be more than the amount necessary to provide for the qualified education expenses of the beneficiary.” This is extremely broad, to receive a more exact dollar amount, one will have to look at the individual state in which the 529 Plan is set up. Later, we will look at the maximum amount at which Arkansas stops allowing contributions.
Qualified Higher Education Expenses have a very specific definition found in IRS Publication 970. We will take a moment to cover this list, as these are very important, and the largest benefit of the 529 Plan. Principal and growth are withdrawn tax-free when used for the below:
Tuition and fees, books, supplies, and equipment for the actual classes. For example, if Hannah has an Intermediate Accounting Class, the cost of the class, required textbooks, pens, pencils, and if a certain type of calculator is required, it is also included.
Expenses for special needs services are needed by a special needs beneficiary. Note, the expenses for special needs services must be incurred in connection with enrollment or attendance at an eligible college or trade school.
Room and board expenses. Note, the student must be enrolled at least half-time, as determined by the school. For example, if James University says that in the Accounting program, 16 hours is a full-time student, then Hannah would have to be enrolled in at least 8 hours for the room and board to qualify. Room and board expenses qualify up to the greater of allowance for room and board as determined by the school, or the actual amount charged if the student is residing in housing owned or operated by the school. For example, if Hannah lives on campus, the room and board expenses could be withdrawn from the 529 Plan tax-free. If however, Jason decides to live at home during welding school, the amount for room and board expenses as determined by the welding school could still be withdrawn out of the account with no taxes!
Computer or peripheral equipment encompasses certain computer software, internet access, and related services. Note, the primary use of the computer, equipment, and internet must be for school purposes, video games are not included.
Student Loans and interest not to exceed $10,000. This amount is over the lifetime of the beneficiary. For example, Matthew, the beneficiary of a 529 Plan has $23,000 of student loan debt. He can use up to $10,000 out of the 529 Plan to pay off student loan debt. This $10,000 could also be used to pay on a sibling’s student loan debt if Matthew didn’t want or need to use it on his student loan debt.
Elementary and Secondary Education expenses with a maximum of $10,000. This means up to $10,000 could be used out of the 529 account for private or public school K-12 tuition over the lifetime of the beneficiary.
Ok, we have looked at the definition of a 529 Plan, and how it can be used. Many people ask: “Is it worth the trouble?” That is a decision you get to make. Let us look at an example. Mr. and Mrs. Smith (Josiah’s parents) decide to contribute $20,000 into a 529 Plan for Hannah their eldest Grandchild, Mr. and Mrs. Johnson contribute $30,000 into the same 529 Plan, and Josiah and Abigail contribute $10,000 to the same plan. The total of these contributions comes to $60,000. Note, the amount could be higher or lower, a positive of the 529 is that contribution amounts are pretty flexible. If this amount is contributed when Hannah is 2 years old, and it grows at a fairly safe rate of 6% by the time she is 18 years old, the $60,000 will have grown to $156,327. You can run your own calculations on any investment calculator to manipulate the data. I have used this one. So, in this case, the principle was contributed and 16 years later, at a 6% growth rate with no additional contributions, the amount in the account is $156,327, less the principle of $60,000, totaling $96,327 of growth. If this money was outside of the account, it would be subject to capital gains, and possibly the net investment income tax as well. So, $96,327 times 23.8% of tax gives us a tax bill of $22,926. So, the tax savings on this 529 example is over $20,000.
To continue the above example, if the $156,327 is not fully used by Hannah, whatever amount is left can be changed to another beneficiary, a “member of the family”, which is defined in two places IRC 529(e)(2) and in IRC 152(d)(2)(A) through (G). By the way, you can’t make this stuff up, the Internal Revenue Code as referenced above in section 152, subsection d, paragraph 2, subparagraphs A through G, with regards to the beneficiary: Child or a descendant of a child of the beneficiary, brother, sister, stepbrother, or stepsister of the beneficiary, father or mother or ancestor of either of the beneficiary, stepfather or stepmother of the beneficiary, son or daughter of a brother or sister of the beneficiary, brother or sister of the father or mother of the beneficiary, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law of the beneficiary, foster child or adopted child, spouse of any of the above list, any first cousin of the beneficiary, and spouse of the beneficiary as well. Basically, every kin and their brother.
The above is actually a very nice perk of the 529 Plan as if there is money left over, the beneficiary can be changed to a good-sized list of people. In the alternative, the money can be distributed to the beneficiary at any point and is taxed at the beneficiary’s tax rate, plus a 10% additional tax. Ok, we have definitely gotten our money out of those Federal tax glasses; so, take them off, stand up, take a deep breath, stretch, and reach for those Arkansas tax spectacles.
Arkansas Tax Perspective
Arkansas has a couple of unique benefits to its 529 Plan. First, an Arkansas 529 can be used at any qualified institution of higher education, and it is not restricted to the state’s borders. For example, if Matthew wanted to attend plumbing school in MO, he could use his Arkansas 529 to pay for it.
A huge perk of the Arkansas 529 Plan is the Arkansas state income tax deduction for contributions. Up to a $5,000 contribution per taxpayer ($10,000 contribution for Mr. and Mrs. Smith) per tax year will reduce the income subject to tax in the state of Arkansas. Now, this is a set amount of $5,000 per taxpayer, it does not matter what the total gift is in the tax year. The maximum amount eligible for deduction is $5,000 per taxpayer. Note, amounts in excess of $5,000 per taxpayer may be carried forward for the next 4 tax years. For example, if Josiah and Abigail decide to contribute $15,000 for 20XX into an Arkansas 529 Plan, they would be allowed a $10,000 deduction and would receive a $5,000 deduction in the following year.
Contributions to an out-of-state 529 plan are allowed a deduction of up to $3,000 per year per taxpayer. For example, Mr. and Mrs. Johnson live in Arkansas, but they have a couple of grandchildren that live in Mississippi, and the grandchildren have a 529 Plan in Mississippi. Mr. and Mrs. Johnson can contribute up to $6,000 to the out-of-state plan, but that is all they would get the benefit for. Of note, rollover contributions up to $7,500 per taxpayer ($15,000 per married couple) are deductible for Arkansas state income tax, if rolled from another state plan. For example, if Mr. and Mrs. Smith (Josiah’s parents) had a 529 in Tennessee, and wanted to roll it to Arkansas, they would get up to a $15,000 deduction on their AR state income taxes.
There is no maximum contribution, nor account value in an Arkansas 529 Plan. However, once the total balances for one designated beneficiary reaches $366,000, no more contributions are allowed. If the above couple of paragraphs have not answered all your questions on Arkansas 529 Plans, visit here. Once an Arkansas 529 has been set up, one can choose how the funds are invested. Wow, congratulations, we have defeated the 529 Plan deep dive.
Ultimately, these plans are fairly simple to set up. If you are interested in more, please read the footnotes for this write-up, as they include tons of information! If there are any questions about the tax ramifications, I encourage you to reach out to your CPA. Whenever Uncle Sam encourages a certain behavior, and it fits your family, might as well reap the tax benefits.
 H.R.3448 – 104th Congress (1995-1996): Small Business Job Protection Act of 1996 | Congress.gov | Library of Congress
 Historical Income Tables: Households (census.gov)
 Publication 970 (2020), Tax Benefits for Education | Internal Revenue Service (irs.gov)
 Publication 970 (2020), Tax Benefits for Education | Internal Revenue Service (irs.gov)