The growing cost of college means that parents or grandparents who intend to pay part or all of the tab for a child need to chart a course. A tax-advantaged 529 plan is one way to save for future education costs.
Although 529 plans have been around since 1996, many parents still aren’t sure how they work. Yet they are worth knowing about in detail.
Read on to get the full story on 529 plans and whether opening one is the right move for you.
529 Plan Basics
Also known as a qualified tuition program, a 529 plan allows a parent (or anyone else) to prepay a student’s college tuition or contribute to an education savings account.
Contributions are not tax-deductible, but distributions are tax-free if they are used for qualified education expenses for the beneficiary.
There are two kinds of 529 plans — named, by the way, for Section 529 of the federal tax code — and every state offers at least one. Learn the difference.
Prepaid Tuition Plan
A prepaid tuition plan allows you to prepay tuition and fees at certain colleges and universities at today’s prices for a child’s future educational needs. Such plans are usually available only at public schools and for in-state students. Only nine are accepting new applicants, and the funds saved are typically not able to be used for room and board.
The main benefit of a prepaid college plan is that you could save big on the price of college by prepaying before prices go up. And contributions are considered gifts, so deposits up to a certain threshold each year ($17,000 in 2023, or $34,000 for a married couple splitting gifts) qualify for the annual and lifetime gift-tax exclusion.
A few special-case guidelines to note:
• If your child doesn’t attend a participating college or university, you will likely be able to use the funds you set aside at another school. Another option may be to transfer the plan to an eligible sibling. What if no one in the family plans on attending college? Most plans will refund your money, perhaps minus a cancellation fee.
• If your state government doesn’t guarantee the plan, you may lose the payments you’ve made if the state runs into budget shortfalls.
• Prepaid tuition plans may charge an enrollment fee and ongoing administrative fees.
• Although most of the plans can’t be used for room and board, Florida Prepaid Plans, for example, offer a prepaid dormitory plan of two semesters of dorm fees for each year of state university coverage.
An alternative to the state-sponsored plans is the Private College 529 Plan, which has over 300 participating institutions nationwide.
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Education Savings Plan
The second type of 529 plan is an education savings plan. Here’s how it works:
• You can contribute monthly, quarterly, or annually, or deposit a lump sum. Beyond parents making regular payments, 529 plans can be a clever way for the extended family to give a meaningful gift on birthdays or holidays. There is no limit on how much you can add yearly, but you’ll have to fill out gift tax Form 709 if you contribute more than the annual gift amount.
• While contributions are not deductible on the federal level, many states provide tax benefits for saving in a 529 plan, such as deducting contributions from state income taxes or giving matching grants. Check your local tax laws to see if you qualify.
• Once you contribute, you will likely have a range of investment options to choose from. These vary from state to state and may include mutual funds and exchange-traded funds (ETFs).
• You may want to tailor your choices to the date you expect to withdraw the money — you can possibly be more aggressive if you have a longer timeline, but may sway more conservatively if you only have a few years. One option is to choose a target-date fund, which would automatically adjust your portfolio to become more conservative as your child’s college years approach. That usually means a greater share of stocks initially and more bonds and cash over time.
• Money can be withdrawn tax-free from a 529 savings plan to pay for any “qualified higher education expense,” which includes tuition, fees, books, computers, and room and board.
• You can make withdrawals as long as your child is enrolled at least half-time at an accredited school, regardless of where in the United States it is, and occasionally abroad. Parents can also withdraw up to $10,000 a year to pay for K-12 tuition expenses and for student loan repayment.
• If you withdraw money for the above expenses, you won’t have to pay federal income tax, and often state income tax, on your earnings. If you withdraw the funds for other reasons, you’ll have to pay taxes, and you may or may not be able to avoid the 529 withdrawal penalty, a 10% federal tax penalty on the earnings.
• Starting in 2024, families with leftover savings in a 529 college savings account may be able to roll it to a Roth IRA tax- and penalty-free. That is one of several retirement savings changes that are part of the Secure 2.0 Act.
One last note: It is possible to change the beneficiary of a 529 plan to another eligible family member. For example, you can switch to a younger child if your oldest got a scholarship. That’s another 529 account benefit to note.
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How 529 Savings Plans Compare With Other Options
Why create any investment plan for your child? Time. By investing funds, 529 accounts give your money the chance to grow over time.
If you just leave your savings in cash or even a high-interest savings account, you may actually be losing money as the years go by, as it likely won’t keep up with inflation.
The 529 plan also has advantages when it comes to calculating financial aid. When you complete the FAFSA, the Free Application for Federal Student Aid, money in these accounts owned by either a dependent student or by a parent is considered a parental asset on the FAFSA. Approximately the first $10,000 won’t be counted toward the expected family contribution.
For more than that, only up to 5.64% of the amount saved counts when the government calculates the “expected family contribution” in deciding on the financial aid package. (For other student assets, up to 20% of the savings can count in the calculation.)
So while a 529 may slightly reduce financial aid, it will likely save more overall by reducing the number of federal or private student loans needed.
New rules affect grandparent-owned 529 plans. Distributions have counted as student income on the next year’s FAFSA, assessed at up to 50%. But starting with the 2023-2024 school year, grandparents’ 529 plan savings will have no impact on the student, which might incentivize parents to contribute to grandparent-owned plans instead of the other way around.
Now let’s look at some options.
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Like a 529 plan, a Coverdell account, also called an Education Savings Account (ESA), is a tax-advantaged savings account to pay for qualified education expenses.
Unlike a 529 account, total contributions from all sources to a Coverdell account cannot exceed $2,000 annually per beneficiary. Another difference is income limits: You can only use an ESA if your modified adjusted gross income is less than $110,000 (singles) or $220,000 (married couples filing jointly).
You can only make contributions until the child reaches age 18, and all funds must be withdrawn by the time the beneficiary reaches age 30. A 529 plan generally does not restrict the age of the beneficiary.
Basic Brokerage Account
Instead of a 529 plan, some families may favor a brokerage account, which affords the freedom to choose whatever investments they want and the ability to use proceeds for any need a young person has.
The main benefit of a 529 plan is that you don’t have to pay capital gains tax on any distributions used for qualified education expenses. Many families, however, pay a 0% long-term capital gains tax rate anyway. (Long-term capital gains apply to a security held for a year or more. The day-to-day increases or decreases in an asset’s value before it is sold are unrealized gains and losses.)
For 2023, married couples filing jointly with taxable income of $89,250 or less and single filers with $44,625 or less may qualify for the 0% long-term capital gains rate.
A 529 account, then, may be of greatest use to families that need an additional tax shelter.
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Withdrawals from a traditional IRA before age 59½ that are used for qualified higher education expenses are not subject to the 10% early distribution penalty — but you will still pay income tax on the distribution.
Money in a qualified retirement plan is not reported on the FAFSA, but distributions may be reported as untaxed income, and income is weighted much more heavily than assets for financial aid. Remember that a 529 savings plan will have a limited impact on the financial aid offer a student receives.
It is generally thought that retirement plans should be used for just that, and not for college expenses.
With a Roth IRA, you can withdraw contributions tax- and penalty-free at any time, but distributions will be reported as untaxed income on the FAFSA, reducing eligibility for need-based financial aid.
You generally must be at least age 59½ and have had the Roth account for at least five years to withdraw earnings tax- and penalty-free. If you are under 59½, you may be able to avoid a penalty (but not taxes) if you withdraw earnings to pay for qualified education expenses.
Some people opt to max out their Roth IRA contributions and then invest additional money in a 529 plan.
UGMA and UTMA Accounts
You can open a Uniform Gifts to Minors Act or Uniform Transfers to Minors Act account on behalf of a child under age 18. The adult custodian controls the money, but gifts and transfers irrevocably become the property of the child.
As with a 529 plan, annual contributions to a UGMA or UTMA account are unlimited, and gifts below the annual gift threshold do not need to be reported to the IRS on gift tax Form 709.
Unlike college savings plans, there is no penalty if the account assets aren’t used to pay for college. Once the minor reaches adulthood, the money is turned over to the former minor, who can use the assets for college or anything else.
But custodial accounts have drawbacks when compared with 529 savings plans: The accounts offer no tax benefits when contributions are made. Earnings are subject to taxes. And a custodial account is counted as a student asset on the FAFSA and will weigh more heavily against financial aid eligibility than parents’ assets or assets held in a 529 account or an ESA.
Choosing a 529 Savings Plan
Every state offers a 529 savings plan, but not all are created equal. When trying to find the best 529 college savings plan, you may want to think about the tax benefits and the fees.
First, you may want to understand whether you qualify for a state income tax deduction or credit for your contributions, based on your state of residence and the plan. Check your state laws and consult a tax professional to learn more about your particular situation.
Some states, such as New York, only offer deductions to in-state taxpayers who use their plan. Other states, including Pennsylvania, allow residents to take a deduction regardless of which state’s plan they use.
Some states, like Indiana, offer income tax credits instead of deductions. And other states, such as North Carolina, don’t offer any deductions for 529 contributions.
The next thing you could consider are the fees associated with your plan, which could include enrollment fees, annual maintenance fees, and asset management fees. Some states let you save on fees if you have a large balance, contribute automatically, are a state resident, or opt for electronic-only documents.
For many students, the cost of college can be eased with a tax-advantaged 529 savings plan. The accounts allow for tax-free growth of funds that can help dreams of affording higher education come true.
529 plans are still rarely used, though, whereas most college students take on loans to get through school. If savings and federal student aid don’t cover all the costs of college, a private student loan could be a solution.
Federal programs like income-driven repayment and deferred interest on some federal student loans do not apply to private student loans, but a private student loan can help fill gaps in need.
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Are 529 plans worth it?
A 529 plan can be a worthwhile college savings vehicle, depending on a family’s situation. If the student is definitely going to attend college and if the state of residence offers tax benefits for these savings, or a prepaid tuition plan, it can be a good option.
Why shouldn’t you invest in a 529 plan?
For some people, a 529 may not be the best option. If a family is unsure whether a child will attend college, lives where there aren’t state-level tax breaks for these programs, or thinks they can earn higher returns elsewhere, they might not want to open a 529 college savings plan.
Is a 529 plan better than a savings account?
A savings account offers more flexibility than a 529 college savings plan, but it won’t offer the tax advantages that a 529 does. With a 529 account, contributions will grow tax-free, and withdrawals for qualified education expenses are also not subject to taxes.
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