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Benefits of Using a 529 College Savings Plan

By Janet Siroto · August 09, 2021 · 9 minute read

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Benefits of Using a 529 College Savings Plan

Most parents want their children to get the best higher education possible, and for the majority of Americans, that means a four-year college. However, that dream comes with a high price tag: to be specific, an average of $141,324 in total. The growing costs of college mean parents who intend to help foot the bills need to plan and do so as early as possible.

One way to save for college tuition is through a 529 college savings plan, named for the relevant section of the federal tax code.

While these 529 plans have been around for more than 20 years, many parents still aren’t sure how they work. Yet they are definitely worth knowing about in detail: 529 plans can be an effective way to save for your child’s education while taking advantage of tax benefits.

Read on to get the full story on 529 plans and whether opening one is the right move for you, including:

•   How do 529 plans work?

•   How do 529s compare vs. other college-savings plans?

•   What are the benefits of a 529 plan?

•   How should I choose a 529 plan?

529 Plan Basics

First things first: Here’s the definition of a 529 plan. Also known as a “qualified tuition plan,” it is a type of tax-advantaged account that allows savings to grow through investment, but funds may only be withdrawn for certain educational expenses.

There are two kinds of 529 plans, 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, though there are exceptions. Only a few are accepting new applicants, and the funds saved are typically not able to be used for room and board expenses.

The main benefit of this 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 $16,000 a year qualify for the annual gift-tax exclusion.

A couple of special-case guidelines to note:

•   If your child doesn’t attend a participating college or university, you will probably lose the benefit of prepaying tuition at a lower cost but 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.

•   The plans usually can’t be used for room and board, as mentioned above. However, there are some that will accommodate this. Florida Prepaid plans, for example, offer a prepaid dormitory plan of two semesters of dorm fees for each year of state university coverage.

Education Savings Plan

The second type of 529 plan is an education savings plan. Here’s how it works:

•   You can contribute monthly, quarterly, 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. The contribution limit is $16,000 per year for tax benefits, but there is no limit overall on how much you can add.

•   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 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.

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 Plans Compare to Other Options

When you compare them to other methods of saving for college, the advantages of 529 plans can be compelling. By investing the funds, these 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 fill out the Free Application for Federal Student Aid (FAFSA®) , money in these accounts owned by either a dependent student or by a parent are considered parental assets on the FAFSA. Approximately the first $10,000 won’t be counted towards 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.)

The bottom line is that while a 529 plan may slightly reduce available financial aid, it will likely save much more overall by reducing the number of loans that need to be taken out.

Now, let’s look at some options: If you put your college savings in an online IRA, that won’t be counted as a parental asset on the FAFSA since it’s a retirement account. The 529 plan, though, comes with more tax benefits. Specifically, you can withdraw both contributions and earnings any time from a 529 plan without paying taxes or penalties, as long as it’s for qualified educational expenses.

With a Roth IRA, you generally must be at least age 59 ½ and have had the account for at least five years to withdraw earnings tax- and penalty-free. There may or may not be penalty-free deductions for college expenses; check your particular IRA’s guidelines and see what decision is right for you.

Another aspect of Roth accounts to consider: Unlike 529 plans, you can only contribute if you fall below a certain income threshold ($144,000 for head of household, single, or married filing and living separately). There’s also a limit to how much you can put in each year ($6,000 for most individuals in 2022, or $7,000 if 50 or older).

Additionally, some 529 savings plans allow you to deduct contributions on your state income taxes, while any contributions to Roth IRA accounts are with after-tax dollars.

Recommended: FAFSA Guide

Benefits of a 529 Plan

That’s a lot of information to absorb, but saving for college is a major undertaking with major benefits. Here, a summary of 529 plan benefits:

1.    Options! You can decide between an education savings plan or a prepaid tuition product. Depending on your particular financial situation and the student’s outlook, there’s likely a very good choice available. Plan options will vary state by state and require some time to study exactly what’s available and find the right match.

2.    Your money grows free of taxes over time. What’s more, when you take out your money for qualified educational expenses, you don’t pay taxes on the gains.

3.    You may be able to get an income tax break at the state level on the money you stash in a 529 plan. Check your state’s guidelines to see if this is a possible advantage.

4.    You may be able to change the beneficiary. If the child whose education was saved for decides not to go to college or wants to attend a college other than one designated in a prepaid plan, you may be able to swap in another family member.

5.    The funds may be applied to K-12 education or to student-loan repayment. This could be a huge help in the overall picture of paying for educational expenses.

6.    The money in a 529 savings plan may in some cases be invested in stocks funds or in another market-based investment. This could allow for greater growth than what a typical savings account is likely to achieve.

7.    These plans don’t have income restrictions; they can be accessed by consumers of all earnings levels.

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.

The Takeaway

Ah, a college degree, something that 74% of new jobs frequently require. Achieving that diploma takes hard work and dedication, as does saving to pay for it. For many students, the cost of college can be eased with a tax-advantaged 529 plan. These programs allow for tax-free growth of funds in two different ways that can help dreams of affording higher education come true.

Looking for another option to pay for your child’s education?

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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, 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 about whether a child will attend college, lives where there aren’t state-level tax breaks for these programs, or believes 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 expenses are also not subject to taxes.

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