If you’re a parent saving for college, you have probably heard about 529 plans, which offer tax advantages and conservative investment options that make it easy to save money for post-secondary education expenses. With a 529 savings plan, you can avoid student loans and still obtain need-based aid.
A few key benefits of 529s include:
Read on to learn more.
A 529 College Savings Plan (referred to as Qualified Tuition Programs or QTPs by the IRS) is a college savings plan named after section 529 of the federal tax code. Using a 529 plan, account holders can either prepay a beneficiary’s tuition or fund an account that can be used for qualified educational expenses at an eligible institution. The IRS designed 529 plans to help families save for college without being penalized for taxes. States, state agencies, and educational institutions can establish 529 plans.
Who can own a 529 account?
Anyone, including parents, grandparents, other family members, and friends, can open an account for an eligible beneficiary. Parents and grandparents can open separate 529 accounts for a child at the time of birth. Although it’s most common to open a 529 account for dependents, you can also open a 529 account for your own educational expenses and name yourself a beneficiary.
529 Prepaid Accounts vs. 529 College Savings Accounts
There are two different types of 529 plans—529 College Savings Plans and 529 Prepaid Tuition Plans.
A 529 College Savings Account can be used at any eligible institution and is usually created by a state or state agency. Although states are not required to have a 529 plan, as of 2018, every US state has at least one 529 plan, and some states have multiple 529 plans. Requirements vary for 529 college savings accounts, but in most cases, you don’t have to be a resident of a specific state to use their 529 plan. You can reside in California, invest in Utah’s My529 plan, and the beneficiary can use the 529 money to attend college in Arizona.
With a 529 college savings account, you can pay the following types of expenses:
College costs that are not considered qualified education expenses include:
529 Prepaid Tuition Plans are not as popular as 529 college savings accounts, and not every state has one. These plans allow you to prepay tuition by contributing a certain amount annually. The annual contribution is converted to a “tuition certificate,” which can be applied to a year of tuition at a partner school. In many cases, states that offer 529 prepaid tuition plans have strict age, residency, and expiration requirements. State plans are usually limited to specific in-state schools. Institutions or a group of institutions can also create and manage 529 prepaid plans. One example is the Private College 529 plan, which partners with over 300 private colleges.
With a 529 prepaid tuition plan, expenses are limited to tuition and mandatory fees.
How Does a 529 plan affect financial aid?
If the beneficiary of a 529 plan is a dependent of their parents, the 529 plan is considered a parental asset. The 529 plan is assessed at 5.64% of its worth. For example, if you have $100,000 saved in a 529 college savings account, only $5,640 will be assessed as part of the beneficiary’s Expected Family Contribution (EFC). For parents who are concerned about financial aid eligibility, a 529 college savings plan is ideal.
Where can I use a 529 plan?
For 529 prepaid tuition plans, the plan must be used at a partner institution, which is specified by the plan. Most state-run 529 plans partner with local, in-state schools. Other plans, such as the Private College 529 have a partnership network of over 300 schools in a variety of states in the U.S.
For the 529 college savings account, an eligible educational institution is any institution that is eligible to receive and distribute federal financial aid. The US Department of Education has a downloadable list of 2019 eligible educational institutions, or you can use the school search feature on the Free Application for Federal Student Aid (FAFSA) website. While 529 plans are most commonly used at four-year colleges and universities, the plans can also be used at graduate schools, community colleges, private academies, trade, and vocational schools.
There are many factors to consider when choosing a 529 plan, including the college you will attend, higher education expenses, investment options, financial aid, and tax deductions.
Your choice for a 529 plan may be different for each child, or you might choose to have multiple plans for the same child. For example, a grandparent may open a 529 prepaid tuition plan in a different state. You can transfer money between the 529 plans and even change the beneficiary of a given account.
The type of college your child hopes to attend will impact the 529 plan you choose. Prepaid tuition plans are more limited than college savings plans. Prepaid tuition plans are limited to hundreds of schools and can only be used for tuition and mandatory fees.
For most families, the 529 college savings account is a better option because of the flexibility it offers. A 529 college savings account can be used at any eligible US institution and is not limited to a list of partner schools. A 529 college savings account can be used for a variety of expenses including room and board, computers and internet, and books, in addition to tuition and mandatory fees.
TIP: If you don’t know which college your child will attend or if they plan to attend a private or out-of-state college, choose a 529 college savings plan. If your child plans to attend an in-state public school, review available 529 prepaid tuition plans in your state.
Higher Education Expenses
For most parents, higher education expenses are not covered by savings accounts. To figure out which plan is best for you, complete a college budget checklist and take into account where your student plans to attend college. If the beneficiary is leaning towards an out-of-state school, you’ll need to factor in ground transportation or plane tickets, furniture, housing, and food expenses. On the other hand, if the student plans to attend a nearby college while continuing to live at home, your expenses may be limited to tuition.
TIP: If your higher education expenses are limited to tuition only, try to find a 529 prepaid tuition plan. If you need to cover a variety of expenses, consider a 529 college savings account that can be used in any state.
Most 529 plans offer a limited variety of investment options to choose from. The plan administrator (e.g. the state or institution) always determines the offerings, but you can hire a qualified investment advisor to help you choose the best options based on what is available. Some college savings accounts and most prepaid tuition plans use an age-based investment model that offers aggressive options when the beneficiary is younger and more conservative investments as the beneficiary reaches college age.
It’s important to remember that 529 plans are investment accounts and do involve some risk. Before choosing a 529 plan, you can consult with a tax advisor and the plan administrator to find out which options are available. A qualified financial advisor can help you choose the best option based on the beneficiary’s age and the contribution you can make to the account.
TIP: If your child is older than ten, choose a plan without age restrictions that will allow you to maximize your investment in less time. If your child is younger than ten, choose an age-based plan that will maximize your investment as the beneficiary reaches college age.
Income and Age Restrictions
There are no income restrictions for 529 college savings plans or prepaid tuition plans.
Most 529 college savings plan do not have age restrictions, but some 529 prepaid tuition plans do. Also, the plan imposes limits on when the money must be used—usually before the beneficiary reaches age 30 or thirty years after the first tuition certificate is purchased. The following is a list of just a few 529 prepaid tuition plans with restrictions:
How does investing in a 529 plan affect federal and state income taxes?
There are no federal tax deductions specific to a 529 plan, but you can accrue earnings in the account tax-free, so long as the money is used for a qualified higher education expense. State tax benefits vary by state.
529 plans have very high contribution limits that are designed to reflect the total cost of undergraduate and graduate education for college savings plans, and undergraduate education for prepaid tuition plans. The lifetime contribution limits for most 529 plans ranges from $200,000 to $500,000, in most cases.
However, unless the beneficiary is yourself, 529 contributions are considered gifts, and the IRS imposes a gift tax on contributions over a certain amount. This means that a parent can contribute up to $15,000 per year to each child’s 529 before they are taxed, or a married couple can contribute $30,000 total ($15,000 each) to each child’s 529 before they are taxed. The gift tax also applies to grandparents, relatives, friends, and anyone else who contributes to a 529 plan.
Individuals also have the option to “superfund” a 529 account by giving a five-year annual gift at once. The benefit of superfunding the account is that with a higher starting balance, the account will accrue higher earnings. Individuals can donate up to $75,000 (couples can donate $150,000) at one time. However, you cannot give another monetary gift to the beneficiary within this five-year period without accruing taxes.
How much can you write off on your taxes if you have a 529 savings plan?
State tax deductions vary. Some states offer a maximum of $1,000 per year, while others allow up to $10,000 per individual ($20,000 per couple) to take into account when calculating income tax.
Penalties, Fees, and Non-Qualified Distributions
There are two conditions for avoiding taxes and penalties for 529 distributions.
If you misuse the funds in a 529 account, the 529 distribution counts as income. There are obvious ways that individuals incur tax penalties on their contributions, but more commonly families incur a penalty in one of the following situations:
If you spend more than the QHEE, even if it is on qualified expenses like books and room and board, the excess amount is considered an ineligible expense and subject to federal and state income tax. For example, if the university publishes the estimated cost of attendance as $40,000, but you spend $45,000, the additional $5,000 is a non-qualified expense. The most common way that families do this is by exceeding the room and board allowance when using off-campus housing.
If the distribution is considered a non-qualified expense, it is subject to a 10% federal tax penalty. In addition, you must pay income taxes on the earnings portion of withdrawals. This is important to note because you do not pay tax on the full distribution, just a portion of the accrued interest. The amount is also subject to state income tax.
Scholarship, Military Academy, Disability, Death
There are four cases in which 529 account holders will avoid the 10% tax penalty. If the beneficiary attends military school, becomes disabled, or dies, the money in the 529 account may be withdrawn without the 10% tax penalty. If the beneficiary earns a scholarship, the account holder can withdraw up to the amount of the scholarship.
However, in all cases, the account holder will still be required to pay taxes because the distribution is considered taxable income. To avoid paying taxes, the money in the account can be transferred to another 529 account, you can change the beneficiary to an eligible family member, or you can transfer the money in the account to an Achieving Better Life Experience (ABLE) account for the beneficiary or an eligible relative.
How much is your state's 529 tax benefit really worth?
State tax deductions for 529 contributions vary widely. Some states have no income tax and do not offer deductions; others have a state income tax but do not offer deductions. Some limit deductions to 529 account holders contributing to the state plan, while others offer state tax deductions to individuals contributing to any 529 plan, even if it is in another state. For example, in Illinois’ Bright Start, Bright Directions, and College Illinois! 529 plans, up to $10,000 can count towards the individual contribution deduction, while in Indiana residents may only deduct a maximum yearly credit of $1,000.
If you are saving money for your child to use for college, the 529 education savings plan and tuition plan are not your only option. Coverdell Education Savings Accounts (ESA) and the Uniform Gifts to Minors Act (UGMA) are two other options that parents use to set aside money for their children’s education. When considering a 529 college savings plan vs. other investments, it’s important to think about the long-term goals and implications for the money you’ve saved.
Uniform Gift to Minors Act (UGMA)/ Uniform Transfer to Minors Act (UTMA) vs. 529 Plans
The key difference between the UGMA/UTMA account and 529 plan is their purpose. UGMA/UTMAs are custodial accounts that transfer ownership to the minor once they become of age, while 529 plans are designed to save for tuition and qualified education expenses for beneficiaries but remain in control of the account holder.
If there is serious doubt as to whether your child will attend college, or you want to ensure the money remains in control of the beneficiary, a UGMA/UTMA account is a better option. Since 529 plans are limited to higher education expenses, you risk paying penalties and federal tax, and losing state tax benefits if the beneficiary decides not to attend college and you choose not to transfer the 529 account to an eligible family member.
Coverdell Education Savings Accounts (ESA) vs. 529 Plans
Both the Coverdell ESA and 529 plan offer investment options for parents planning to save for their child’s education. The key differences are due to significant income and contribution restrictions imposed on the Coverdell ESA. For some parents, choosing between a Coverdell ESA and 529 is not a choice because they do not meet requirements for an ESA.
When is a 529 savings plan not the right choice for your family?
A 529 plan is an excellent way to save for college and potentially earn tax credits, but it’s not for everyone. The essential thing to remember about a 529 plan is that it is for college. (In some cases, a 529 can also be used for K-12 tuition). If for any reason the beneficiary decides against attending college, the money may be taxed. It’s equally important to remember that the money belongs to the account holder and not the beneficiary.
If you are saving for college and you have at least two or three years, a 529 college savings plan is likely your best bet. If you need help choosing a 529 plan, it’s best to speak with your tax professional to discuss tax implications before choosing a plan. You can also speak with the plan administrator to obtain information about investment options, restrictions, tax benefits, and other account information.