What is a 529 Plan and Should You Get One?

A 529 plan is a powerful tool designed for long-term education savings, offering tax advantages that make it an attractive option for families preparing for educational expenses. Understanding the nuances of 529 plans, such as the types available, contribution limits, and tax benefits, is crucial for informed decision-making. This article explores the intricacies of 529 plans, delves into alternative education savings options, and provides insights into opening and managing these accounts.

What is a 529 Plan?

A 529 plan is a specialized savings account designed to facilitate long-term savings for education expenses. Named after Section 529 of the Internal Revenue Code, these plans are administered by states, state agencies, or educational institutions. On the other hand, education savings plans involve investing contributions in various securities to grow the account over time, with withdrawals used to cover qualified education expenses.

While contributions are not federally tax-deductible, the investment earnings within the account grow tax-deferred. Importantly, withdrawals for qualified education expenses, including tuition, room and board, books, and other related costs, are tax-free at the federal level. This tax-efficient structure makes 529 plans attractive for families looking to save for education costs while potentially minimizing their tax burden.

Types of 529 Plans

There are two main types of 529 plans: education savings plans (ESPs) and prepaid tuition plans (PTPs).

Education savings plans (ESPs)

ESPs are the most common type of 529 plan. They allow you to save money in various investment options, similar to a 401(k), such as mutual funds, bond funds, and exchange-traded funds. Your savings grow tax-deferred, and withdrawals are tax-free as long as they are used for qualified education expenses.

Prepaid tuition plans (PTPs)

PTPs allow you to purchase tuition credits at today’s tuition rates for future use at participating colleges and universities. The value of your tuition credits grows tax-free, and you can use them to pay for tuition and other qualified education expenses at any participating school.

529 Contribution Limits

The specific contribution limits depend on the state’s rules governing the 529 plan. Some states set relatively high limits, allowing for substantial contributions over time, while others may have more modest restrictions. Contributors must be aware of the federal gift tax rules and the particular regulations of the state administering the plan. Exceeding the contribution limit may result in tax consequences, including potential gift taxes on the excess amount contributed.

529 plans have contribution limits set by each state, which can vary. Generally, states establish a maximum amount that can be contributed to a 529 project on behalf of a particular beneficiary. While there is no federally mandated limit, state-imposed caps aim to ensure that the plans are used for their intended purpose—covering qualified education expenses. It’s important to note that contributions to 529 plans are considered gifts for tax purposes.

Here are some tips for 529 contributions, including:

• Start saving early. The earlier you start saving, the more time your money has to grow.
• Take advantage of the five-year gift tax exclusion if you can afford to, and make a larger contribution to your 529 plan by using the five-year gift tax exclusion.
• Consider contributing regularly. Setting up a recurring contribution is a great way to save consistently over time.
• Compare different 529 plans before you choose one. Consider the investment options, fees, and state tax benefits other plans offer.
• Choose a plan that is appropriate for your investment goals and risk tolerance.

What Counts as a “Qualified Education Expense’’?

The most important qualified education expenses for 529 plans can encompass various items directly associated with pursuing education. This includes costs for special needs services, such as adaptive equipment or tutoring, necessary for a special needs beneficiary in connection with their enrollment or attendance at an eligible educational institution.  A qualified education expense is related to a student’s education at an eligible institution. Qualified institutions include colleges, universities, and vocational schools.

The specific criteria for what qualifies as an eligible expense can vary, and staying informed ensures that contributors and beneficiaries can make the most of the tax advantages offered by 529 plans. Consulting with a tax advisor or financial professional can provide personalized guidance based on individual circumstances and the most up-to-date regulations.

Here are some examples of qualified education expenses:

• Tuition and fees
• Room and board
• Books and supplies
• Computers and related equipment
• Transportation to and from school
• Disability-related expenses

What to Do with a 529 Account if Your Child Doesn’t Attend College?

If your child drops out of college, you may question what to do with their 529 plan. Depending on your 529 plan and state, you have several alternatives. Changing the beneficiary to a sibling or cousin keeps the money in the family for schooling. Flexibility lets you adapt to changing circumstances and use tax-advantaged investments for a relative’s education.

Keep 529 savings for future use. Unlike certain savings vehicles with age restrictions, the funds can be used anytime. This option offers a longer planning horizon if the original beneficiary studies later.

Consider these factors if your child doesn’t attend college when considering what to do with your 529 plan:

• State tax benefits: Some states offer tax benefits for 529 plan contributions. If you withdraw the money from the plan, you may have to pay back those tax benefits.
• Financial aid: 529 plan assets can affect your child’s financial aid eligibility. If you transfer the money to another beneficiary or withdraw the money, your child’s financial aid eligibility may change.
• Fees: Some 529 plans charge fees for withdrawing money from the plan. Check with your plan administrator to see if any fees are associated with starting capital.

Pros and Cons of a 529 Plan

To make the most of a 529 plan, it’s best to have wholistic understanding of it’s pros and cons.

Pros

• Tax-advantaged growth: Contributions to a 529 plan grow tax-deferred, and withdrawals are tax-free as long as they are used for qualified education expenses. This means your savings can grow faster than in a traditional savings account.
• Flexible investment options: 529 plans offer various investment options so that you can choose a risk level appropriate for your savings goals and time horizon.
• High contribution limits: 529 plans have high contribution limits so that you can save significant money for your child’s education.
• No impact on financial aid eligibility: 529 plans do not affect your child’s eligibility.
• Portability: 529 plans are portable, meaning you can transfer your account to another state if you move.

Cons

• Must use funds for education: Withdrawals from a 529 plan must be used for qualified education expenses. If you use the funds for non-qualified expenses, you will likely have to pay taxes and penalties on the earnings.
• Early withdrawal penalties: If you withdraw money from a 529 plan before the beneficiary reaches age 59½, you may have to pay a 10% penalty.
• Fees: Some 529 plans charge fees, such as annual maintenance fees and investment fees.
• Complexity: 529 plans can be complex, and there are a lot of rules and regulations to be aware of.

529 Account Tax Benefits and Penalties

One of the important advantages of 529 account contributions is grow tax-deferred, meaning you do not pay taxes on the earnings yearly. Withdrawals from a 529 account are tax-free if used for qualified education expenses, such as tuition, fees, room and board, books, and supplies.  One significant advantage is the tax-free growth of earnings within the account.

While contributions are not federally tax-deductible, the investment gains generated over time are not subject to federal income tax as long as withdrawals are used for qualified education expenses. This tax-free growth allows contributors to accumulate more funds for educational needs than taxable savings accounts.

Tax Benefits of a 529 Account

• Tax-Free Growth: Earnings within a 529 account grow tax-free, giving contributors the potential for greater accumulation than taxable savings accounts.
• Federal Tax-Free Withdrawals: Qualified withdrawals from a 529 account for eligible education expenses, including tuition, fees, books, and K-12 education expenses.
• State Tax Benefits: Many states offer additional tax benefits, such as deductions or credits, for contributions to their respective 529 plans. State benefits vary, so it’s essential to check the plan’s specific rules.

Penalties for Non-Qualified Withdrawals

• Income Tax on Earnings: If funds are withdrawn for non-qualified expenses, the earnings portion is subject to federal income tax, diminishing the overall tax benefits.
• Penalty on Earnings: Besides income tax, a 10% penalty is imposed on the earnings portion of non-qualified withdrawals. The principal contributions can be withdrawn without penalty.
• Exceptions for Special Circumstances: Certain exceptions exist for the 10% penalty, such as the beneficiary’s death, disability, or receipt of a scholarship. However, income tax may still apply to the earnings in these cases.

How a 529 Plan Affects Federal Financial Aid

529 plan assets are considered parental if owned by the parent or student, but if owned by a grandparent, they are not counted on the FAFSA. Withdrawals from a 529 plan for eligible education expenses do not impact financial aid eligibility, as they are not considered income. To reduce the impact on federal financial aid, consider having a relative other than the parent or student own the 529 plan. Using 529 plan withdrawals for qualified education expenses is a smart way to fund college without affecting financial assistance eligibility. If additional costs like room and board are not typically covered by financial aid, consider tapping into the 529 plan. In summary, 529 plans are effective for college savings without adverse effects on federal financial aid.

How to Open a 529 Plan

The first step to open a 529 plan involves thorough research to identify a plan that aligns with your preferences, considering factors like fees, investment options, and state-specific tax benefits. Once a suitable plan is selected, gather the necessary information for the account owner and beneficiary, including Social Security or taxpayer identification numbers. Many plans offer diverse portfolios to cater to various risk tolerances. Complete the application form provided by the chosen plan, supplying personal details, specifying contribution allocations among investment options, and optionally nominating a successor account owner. This straightforward process is designed to make education savings accessible and efficient, allowing individuals to kickstart their contributions and secure financial support for educational endeavors.

Here is a step-by-step guide on how to open a 529 plan:

1. Choose a plan sponsor: You can compare different plan sponsors and plans on the College Savings Plans Network website: https://www.collegesavings.org/.
2. Create an account: Once you have chosen a plan sponsor, you can create an account online or by phone.
3. Choose an investment option: Most 529 plans offer various investment options, so you can choose a risk level appropriate for your savings goals and time horizon.
4. Start making contributions: You can contribute to your 529 plan online, by mail, or by automatic transfer from your checking or savings account.

Education Savings Alternatives to 529 plans

Several alternatives exist for individuals seeking education savings options beyond 529 plans. Each choice has its own advantages and considerations, providing flexibility to cater to different financial goals and preferences. Here are some notable options:

• Coverdell Education Savings Account (ESA): Like a 529 plan, Coverdell ESAs offer tax-free earnings growth and withdrawals for eligible education expenses. Although income limits apply, contributors can provide $2,000 per beneficiary per year.
• UTMA/UGMA Custodial Accounts: Under UTMA and UGMA, parents or guardians can open custodial accounts for kids. Utilize these accounts for anything beyond education for flexibility. The child controls funds at 18 or 21, depending on the state.
• IRA Roth: Mostly a retirement account, a Roth IRA can also be used for schooling. Qualified Roth IRA distributions, including education costs, are tax-free. Roth IRA contributions (but not earnings) can be withdrawn penalty-free anytime…more freedom.
• Accounts ABLE: ABLE funds can be used for education, even if they’re for disabled people. After-tax contributions, tax-free gains, and tax-free payouts for eligible disability expenditures.
• Investments taxable: Traditional brokerage accounts permit unlimited use but require greater tax benefits than school savings accounts. They allow unlimited fund use without penalties but don’t offer tax benefits.
• Savings, CDs: Safety and liquidity make traditional savings accounts and CDs excellent for short-term school savings. It may yield lesser returns than other investments.

Final Thoughts

A 529 plan can be a strategic and tax-efficient means to save for education, with benefits including tax-free growth and withdrawals for qualified expenses. However, individuals should also consider alternative savings options with unique advantages. The key lies in aligning the chosen strategy with individual financial goals and preferences. Whether opting for a 529 plan or exploring alternatives, the ultimate aim is to ensure a sound financial foundation for educational pursuits.

Learn More

• What Is the Difference Between a 401k and an IRA?
• Roth IRA vs. 401k – What’s the Difference?

529 Plans FAQ

What is a 529 Plan?

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

Are There Different Types of 529 Plans?

Yes, there are two basic types of 529 plans: Prepaid Tuition Plans and Education Savings Plans. Prepaid Tuition Plans let you pay for future tuition at today’s rates at participating colleges and universities. Education Savings Plans are investment accounts whose value fluctuates based on the market performance of the underlying investments.

Can 529 Plans Be Used for K-12 Education?

Yes, 529 plans can be used for K-12 tuition expenses, but there are limits. You can withdraw up to $10,000 per year per beneficiary for tuition expenses at private, public, and religious K-12 schools.

What Are the Tax Benefits of a 529 Plan?

Earnings in 529 plans are not subject to federal tax and, in most cases, state tax, so long as you use withdrawals for eligible college expenses, such as tuition and room and board. Some states also offer tax benefits for contributions to a 529 plan.

Can Anyone Open a 529 Plan?

Yes, any U.S. resident can open a 529 plan. There are no income restrictions, and you can open an account regardless of your relationship to the beneficiary (child, grandchild, friend, etc.).

How Does a 529 Plan Affect Financial Aid?

Funds from a 529 plan owned by a parent or student are considered when calculating Expected Family Contribution (EFC) on the Free Application for Federal Student Aid (FAFSA), but they have a relatively low impact compared to other assets.

Can I Change the Beneficiary of a 529 Plan?

Yes, you can change the beneficiary of a 529 plan to another family member of the original beneficiary without tax consequences. This flexibility allows families to shift funds between siblings or other relatives.

Are There Contribution Limits for 529 Plans?

While there are no annual contribution limits for 529 plans, there are lifetime limits, which vary by plan. Contributions to a 529 plan are considered gifts for tax purposes, so keeping under the annual gift tax exclusion amount ($15,000 in 2021) is advisable to avoid tax implications.

What Happens if I Don’t Use the Funds in a 529 Plan?

If the funds in a 529 plan are not used for educational expenses, the earnings portion of non-qualified withdrawals will be subject to income tax and a 10% federal penalty tax.

Can 529 Plan Funds Be Used for International Schools?

Yes, 529 plan funds can be used for eligible international schools. The school must be eligible to participate in a student aid program administered by the U.S. Department of Education.

Frank Gogol

I’m a firm believer that information is the key to financial freedom. On the Stilt Blog, I write about the complex topics — like finance, immigration, and technology — to help immigrants make the most of their lives in the U.S. Our content and brand have been featured in Forbes, TechCrunch, VentureBeat, and more.

See author's posts