There are many misconceptions about the 529 college savings plan. This tax-advantaged savings plan is a great option for saving for college expenses; yet more than 70% of Americans are unfamiliar with the advantages it presents.
College costs – as well as student loans – are on the rise. The average in-state college tuition, room and board bills at $20,770, while private college costs are nearly $188,000. It can take years to pay off student debt or college loans. Parents (or grandparents) who own a 529 plan are making a smart investment in their student’s future.
To clarify some of the confusion around the 529 plan, read our guide on who should own the 529 plan, the tax benefits and types of plans available, as well as how to set one up.
The 529 Plan: Background
The 529 plan is an education savings plan that is sponsored by a state or a state agency. It’s named after Section 529 of the Internal Revenue Code (IRC) which authorizes tax-free status for “qualified tuition programs.” The section was added after Michigan established the first prepaid tuition plan, the Michigan Education Trust, in 1986.
A family member can add to the 529 plan and accumulate funds on a tax-deferred basis. Additionally, the 529 plan is not taxed federally when used for higher education expenses. Savings under the plan can be used toward tuition, books, and other education-related expenses. “Qualified tuition programs” means accredited two and four year colleges and universities, U.S. vocational/technical schools, and select eligible foreign institutions. It can be applied to tuition expenses at eligible public, private, and religious primary and secondary educational institutions (K-12).
Though the plans are offered on a state by state basis, you can invest in any state 529 plan. The state plan in which you invest does not dictate the state in which you decide to get an education. For example, you may live in Connecticut, invest in the California 529 plan, and matriculate as a student at a university in Illinois. There are more than 6,000 colleges and universities and more than 400 overseas institutions eligible under the 529 regulations.
Tax Benefits and Types of 529 Plans
There are some key tax benefits to setting up a 529 college savings plan.
First and foremost, the earnings in a 529 plan are federal tax-free. They will not be taxed when the money is taken out to pay for college. Starting last year, tax-free withdrawals were extended to include up to $10,000 in tuition expenses for K-12 education.
In addition to federal tax benefits, more than 30 states also offer some form of tax relief. You may be eligible to receive a full or partial tax deduction or credit for 529 plan contributions. It’s common for most states to allow plan contributors to claim state tax benefits each year you contribute to your 529 plan; experts recommend that you continue to pay deposits into your fund until you’ve completed all your tuition payments.
Another benefit to opening a 529 college savings plan is that the donor is always in control of the account. Whereas other vehicles like the UGMA/UTMA let the child take control of the assets at age 18, the 529 plan retains control with the account donor. And, unlike Roth IRAs, 529 plans are open to everyone: there are no income limits, age limits or annual contribution limits to be able to start a 529 plan for you and your family. There are lifetime contribution limits which vary by plan, and those range from $235,000 – $520,000.
529 plans are flexible and low-maintenance; it’s straightforward to set up the plan, link your bank account, and allow for automatic investments to transfer or take a payroll deduction. There’s no requirement to report contributions to a 529 plan on your federal tax return, and you can change your investment options twice per calendar year. You may make a withdrawal from a 529 account at any time for any reason, but keep in mind that if you use the money for something other than qualified education-related expenses, you will be taxed accordingly.
There are two main categories of 529 plans: prepaid tuition or college savings plans.
- College Savings Plan: this version works similarly to a Roth IRA in that you invest after-tax contributions in a mutual fund or a similar vehicle. Each state’s 529 plan offers a variety of options you can choose from. Then, the account balance will go up or down depending on the investment performance.
- Prepaid Tuition Plan: in this version, a contributor pre-pays all or a portion of the costs for an in-state public college education. This can also be converted towards costs at a private or out-of-state college. Some colleges and universities offer prepaid tuition plans, but not college savings plans.
Which is better: a prepaid tuition plan or a college savings plan?
Think of a college savings plan as a 401k, and a prepaid tuition plan like a pension. Prepaid plans are protected from bear markets and are not tied to how one investment changes relative to another. As a result, when a savings plan loses money, a prepaid plan continues to increase in value assuming that tuition increases.
However, there are drawbacks to the prepaid plan. For most families, the greater return potential and flexibility of a 529 savings plans are a better option. Prepaid plans limit your school choice to options within the state or network. While you may withdraw funds for out-of-state institutions, you will incur a penalty for doing so. In addition, like a pension, a prepaid plan is only as good as the institution backing it. Make sure the plan is backed with full faith by the state sponsor or schools that are required to honor the account holders.
Ultimately, the type of plan you choose depends on your financial circumstances and personal budget considerations. Our experts can help you determine what plan, and which state, offers the best 529 plan for you and your family.
What if my student doesn’t attend college?
Planning for your 529 plan takes years of preparation. A lot can change – including the beneficiary’s desire to attend college. Luckily, the funds in a 529 plan can be used in a few different ways should your child or grandchild choose not to pursue higher education.
First, the beneficiary of a 529 plan can be changed at any point. A beneficiary can be “any qualified family member of your current beneficiary” – including a niece or nephew, another child, or even a daughter- or son-in-law. Or, you can name yourself the beneficiary of the plan.
Depending on your state’s restrictions, the owner of a 529 plan may be able to leave the funds invested indefinitely – and continue to let the money grow. Check with your plan provider to see if there are any age-based rules or regulations about leaving the money untouched. Otherwise, many families keep it invested in case something changes down the road or a new beneficiary (like a grandchild, for example) decides to put the money to use.
You may withdraw 529 money if you are definite that no one will be applying the 529 plan toward their higher education. However, you’ll owe federal and state taxes on the funds, in addition to the 10% penalty on your account’s earnings. If you withdraw the funds as a result of the beneficiary’s death, disability, or because they have earned scholarships and don’t need the money, FINRA may waive that 10% penalty.
Remember: “college” as defined in the 529 plan doesn’t necessarily mean a traditional four-year school. It can be applied to financial aid programs administered by the US Department of Education: from vocational to technical schools and specialty education programs.
Who should own the 529 plan: parents or grandparents?
Before you open your 529 plan, you should be prepared to take full advantage of the tax-free status of your education fund. Many grandparents open a 529 plan for their grandchildren to allow more time for the fund to grow tax-free.
However, there’s a catch to listing grandparents as the owner on your 529 plan. The Free Application for Federal Student Aid (FAFSA) determines how much financial aid a student is eligible to receive by looking at income and assets. This helps them estimate how much parents and a student can contribute to their own education expenses. A 529 plan owned by grandparents does not get reported on a FAFSA application, but when funds are withdrawn and used to pay for college-related expenses, it’s considered income to the student. The student income, unfortunately, does get reported on FAFSA, meaning that the 529 plan can impact a student’s financial aid eligibility IF it’s owned by the grandparents.
A parent-owned 529 plan, however, only reduces eligibility for need-based financial aid by a maximum of 5.64% of the net worth of the assets. FAFSA is aiming to provide financial assistance to those families that are most in need; so, while a grandparent-owned 529 plan may reduce the assistance for the student, it may also help avoid student loans. It’s up to your family to decide whether a parent-owned 529 plan is the better option to FAFSA assistance.
One final caveat: a recent change in the timing of federal aid calculations means that FAFSA estimations are now based on income from two years ago. So, if you are seeking federal aid for 2019, your 2017 tax return will be used to make aid calculations. With a little planning ahead, you can make withdrawals from the 529 plan which won’t impact your income reporting towards FAFSA.
Setting up a 529 Plan
Getting started with your own 529 college savings plan is relatively straightforward. Here is what the process looks like.
- Select your plan. Some of the things you will need to consider are the type of plan (savings, prepaid, or a combination of both); whether to contribute to an in-state or out-of state plan; and the different costs and investment options. Websites like Collegesavings.org or Savingforcollege.com are useful for comparing your various options.
- Gather your documentation. Most states require personal information (your address, birth date, and social security number) as well as the beneficiary information (including his/her birthday and social security number).
- Open the account. Most states let you do this online, but there are some that require you to mail in your application.
- Choose your investments. This is where most people get confused, and it can be helpful to talk to a CPA or accountant about your various options. Many people choose to invest in an age-based portfolio that corresponds to the age of their beneficiary. Remember, you can make two changes per year to your 529 plan investments.
- Submit your application and make a deposit. When you submit your application, you will be asked to either to fund the account immediately by providing your bank information, or you will mail a check along with your application materials.
Each state takes several days or weeks to process your account application. They may come back to you for more information.
If you have questions about the 529 plan, who should own the plan, and what is the best plan for your family, get in touch with the experts at CPA Services. We can help establish the best 529 account for your future student.