What is a 529 Plan, and Should I Get One?

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Building a college fund with a 529 plan can allow you to save tax-free money and help reduce your need for student loans. Contributions can go toward qualified educational expenses for your child, yourself or another beneficiary.

Here’s an overview of 529 savings accounts, including how they may affect your financial aid eligibility and their distribution rules.

What is a 529 plan?
Pros and cons of a 529 plan
How to open a 529 plan
Alternatives to 529 plans

What is a 529 plan?

A 529 plan is a tax-advantaged investment account designed to help save for future education expenses.

These plans initially only covered post-secondary costs, but recently they’ve expanded to include K-12 tuition and certain apprenticeship programs.

There are no income requirements to open a 529 account, but you must be a U.S resident.

Typically, a parent or grandparent owns and controls the 529 account, with the student receiving the funds once they have school-related expenses to pay. Most plans allow you to switch beneficiaries to another family member if the original beneficiary doesn’t attend college or there are leftover funds in the 529 account.

Each state has at least one 529 plan — also known as a “qualified tuition plan” — overseen by Section 529 of the Internal Revenue Code. Some states even provide matching incentives for in-state residents. In addition, certain educational institutions offer an Independent 529 plan — a national prepaid tuition plan for participating private and independent colleges.

It’s important to understand the 529 distribution rules to avoid tax penalties. Basically, you shouldn’t be charged state and federal taxes, but only if the funds are used specifically for qualified education expenses. (See below for more details.)

Here are some more details on how it all works:

Types of 529 plans
529 contribution limits
What counts as “qualified education expenses”?
What to do with a 529 account if your child doesn’t attend college

Types of 529 plans

You have two choices when selecting a 529 plan:

  • Savings plan: This is the most popular option, allowing you to contribute regularly as your account’s earnings grow. You take on more investment risk, but this type allows your child to use the funds at most public and private schools.
  • Prepaid tuition plans: You lock in current tuition rates at in-state public institutions. But if your child decides to go to a private or out-of-state institution, you might receive only a small return on your original investment.

529 contribution limits

Each state sets its lifetime contribution limit per beneficiary. For example, the maximum amount allowed in an individual’s combined 529 accounts in North Carolina is $500,000.

Furthermore, you may need to pay a federal gift tax if you contribute a significant amount to an individual’s 529 account. The 2022 federal gift tax limit is set at $16,000 ($32,000 for married couples) — meaning an annual contribution below this amount should remain tax-free.

If you have friends and family wanting to contribute to a child’s 529 account, consider creating a free account at the Gift of College or Ugift. You’ll receive a shareable link and can funnel the college funds directly into your child’s 529 account.

Pro tip: Superfunding
You can “superfund” someone’s 529 account by contributing up to $80,000 (or $160,000 per couple) in one year. This uses up your federal gift tax allowance for five years but allows the account to grow more substantially.

What counts as a “qualified education expense”?

You can use 529 withdrawals to pay for tuition, room and board, some supplies (including required textbooks and laptops) and school-related services for special-needs students.

However, some school-related costs are not official 529 expenses. As always, you’ll want to read the fine print to make sure what’s covered, but some examples of expenses that may not be allowed when using your 529 money include:

  • College applications and testing
  • Health insurance
  • Travel expenses
  • Sports and club activity fees
  • Some personal expenses, such as dorm room furniture and decorations
  • Room and board beyond what school housing would cost

Note that you won’t be able to spend more than your school’s cost of attendance, regardless of how much is in your 529.

Make sure to keep records of all school-related expenses, such as receipts for textbooks, housing payments and tuition.

What to do with a 529 account if your child doesn’t attend college

You might be concerned that your child might decide not to attend college — and that could leave you with a full savings plan and no way to use it.

Luckily, most 529 plans allow you to change beneficiaries to another family member once a year without tax consequences. Maybe a younger child in the family could use the funds, or you yourself might consider returning to school. You could also roll over one 529 plan balance into another plan if one of your children doesn’t need the money.

If you have a family member who already went to school and accumulated student loan debt, you could use 529 plan funds to help repay it. Thanks to the 2019 Secure Act, you can use up to $10,000 of 529 savings toward student loan repayment.

Pros and cons of a 529 plan

There are many benefits to opening and contributing toward a 529 plan. However, it’s important to consider the disadvantages before deciding whether it’s a smart move for you and your family.

529 plans
Pros Cons
● Multiple plan options
● Flexibility to access out-of-state plans
● Potential tax advantages
● Funds can be used for K-12 tuition and apprenticeship programs
● Ability to switch beneficiaries
● Certain plans impose administrative or annual fees
● Savings could reduce need-based aid
● Penalties for noneducational withdrawals
● Limited investment options

Pros

The 529 plan has plenty of advantages, including the flexibility to choose between a savings or prepaid tuition account. Furthermore, you can transfer a custodial account to a 529 plan to maximize savings (see below for more details).

Another key benefit is the ability to open a 529 plan in any state, regardless of where you live. This is ideal if you find a higher level of return with an out-of-state plan. On the other hand, certain states offer rewarding in-state tax incentives, so definitely weigh the pros and cons of each before moving ahead.

The 529 plan can also be a way to pay for your child’s K-12 private school education, apprenticeship program or to help cover costs if you decide to return to college as an adult. And if you or your child do not need the funds, you can easily transfer them to another family member.

Cons

Most 529 plans include an administrative or annual fee, which tends to be around 0.14% to 0.53%. In addition, your investment options are limited with a 529 plan, as opposed to a brokerage or Roth individual retirement account (IRA), which gives you complete freedom to buy and sell whichever securities you want.

Another downside to the 529 plan is that the funds might be counted as “assets” when applying for federal financial aid (see below for more details). You’ll also need to use the money for qualified educational purposes — otherwise, you’ll face taxes and penalties.

529 account tax benefits and penalties

The main advantage of a 529 college savings plan is that taxes are deferred. However, you’ll likely face taxes plus a 10% penalty if you don’t apply the funds toward qualified education costs. However, the 10% withdrawal penalty can sometimes be waived for extenuating circumstances, such as if the beneficiary dies or gets a disability.

In addition, if your child earns a scholarship, fellowship or employer-based tuition assistance, they might be allowed to withdraw an equal amount from their 529 account without penalty (though the award itself will still be taxed).

And although you can’t deduct 529 contributions on your federal tax return, some states offer state income tax deductions and tax exemptions on withdrawals.

How a 529 plan affects federal financial aid

After a student applies for federal financial aid via the Free Application for Federal Student Aid (FAFSA), the government will look at their and their parents’ assets and decide their Expected Financial Contribution (EFC).

Here’s the good news: If the 529 account is under a parent’s name, it’s considered a parental asset. According to the federal financial aid formula, only 5.6% of parental assets are expected to go toward a student’s annual college costs. This amount increases to 20% for student-owned assets.

What does this mean? Let’s say you saved $6,000 in your child’s 529 college savings plan. If the account is under your name, your child’s aid package may be reduced by only $336. However, their aid may drop by a much heavier $1,200 if the account is solely in the student’s name (such as with custodial accounts — see below).

In addition, private schools may consider your current 529 funds when determining financial aid for elementary and secondary school tuition, even if you’re saving those funds for college.

But while 529 accounts may (slightly) limit a student’s eligibility for federal grants, work-study programs and subsidized loans, they can still be worth it. Many families need to take out multiple student loans to cover the rising cost of higher education, and 529 funds can significantly reduce overall student loan debt.

What about grandparent-owned 529 accounts?

A grandparent-owned 529 account won’t affect a student’s financial aid package, since FAFSA doesn’t look at grandparents’ assets. However, the student will need to report up to 50% of their 529 distributed funds as untaxed income, which can negatively impact future financial aid.

Currently, a workaround is to transfer ownership from grandparent to parent, which some states allow. But FAFSA rules are set to change in the 2024-25 school year: Grandparent-owned 529 distributions will no longer count as untaxed student income. Plus, FAFSA will remove questions regarding cash gifts from grandparents.

The bottom line: Grandparents and other relatives outside the immediate family can help pay for college expenses with no negative financial aid implications for students planning to attend college in 2024 or later.

How to open a 529 plan

You can open a 529 directly through any state program or with a broker or financial advisor.

Although you can get a 529 plan in any state, it’s advisable to first research your home state options since you may be eligible for in-state tax advantages. You can also open multiple 529 accounts for the same beneficiary, allowing you to tap into other states’ specific benefits.

Consult a financial advisor to ensure you’re on track with your college savings goals. Alternatively, you can refer to this state-by-state 529 comparison guide to select a plan that suits your family’s needs.

Alternatives to 529 plans

Even with its many benefits, 529 plans have some limitations, as noted above. Because of this, it’s worth exploring alternatives to help save money for college.

Here are six alternatives to 529 plans:

Savings accounts
Roth IRAs
Brokerage accounts
Custodial accounts
Coverdell Education Savings Accounts
ABLE account (529a savings plan)

Savings accounts

You can save for your child’s college expenses through other, more flexible savings products, like a standard savings account or certificate of deposit (CD). Many banks also offer specific college savings accounts.

One downside is that traditional savings account interest is typically much lower than those on investment accounts, as this might make it harder to reach your savings goal as quickly. Plus, there’s another reason to avoid regular savings accounts and CDs: It’s easy to access funds in a savings account, making it tempting to use the money for other things.

Roth IRAs

If you’re looking to invest funds for a potentially larger return, you can consider a Roth IRA. A Roth IRA allows people to invest after-tax earnings for retirement. Plus, retirement funds aren’t included in your Expected Family Contribution (EFC) — you could have millions in there, and FAFSA won’t bat an eye.

You can withdraw your investment earnings early without penalty if you use the funds for college expenses for yourself, a spouse, your children or your grandchildren. And if your child decides not to go to college, you can put the funds back toward your retirement instead.

The main caveat is that the withdrawn Roth IRA funds will be reported as yearly income and may reduce the following year’s financial aid package. Furthermore, Roth IRAs have annual contribution limits: $6,000 (under age 50) and $7,000 (50 and older). This amount might not be enough to help prepare for your child’s college career if you’re simultaneously trying to save for retirement.

Brokerage accounts

A brokerage account is a popular choice among more experienced investors. Brokerage accounts give you access to any investment you want to buy or sell. These can range from stocks and mutual funds to bonds, currency and futures.

Keep in mind that brokerage account funds count as parental assets, meaning 5.6% will be counted toward your EFC. Additionally, there are no tax advantages of saving for college associated with brokerage accounts. You’ll also be responsible for capital gains taxes if your money earns a return.

Custodial accounts

A custodial account is an ideal option if there’s doubt about your child’s educational plans, but you still want to set aside funds for their future.

UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) are two common options — with no stipulation on how funds are spent.

However, these accounts will be treated as your child’s assets, potentially reducing their financial aid package by 20%. Furthermore, you can’t change beneficiaries with a custodial account.

If your child decides to go to college, you can transfer a UGMA or UTMA account to a 529 plan, which will put the assets in the parent’s name. But note that you can’t do the reverse — move 529 funds to a UGMA or UTMA — without incurring fees.

One thing to consider is you’ll have less control over how your child uses their custodial account funds once they reach the age of majority. You can’t legally prevent them from using the funds to take a vacation or buy a fancy car instead of using the money for their education.

Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) is similar to a 529 plan, in that it allows you to put away savings for your child’s education when they are under age 18.

Like with 529 plans, you can avoid taxes by using distributions for qualified educational expenses. You can also use the funds to pay for elementary and secondary school costs.

However, a student can’t receive more than $2,000 per year with a Coverdell account. As a result, this might not be the best plan for those wanting to save more.

In addition, you can’t establish a Coverdell account if your modified adjusted gross income is higher than $110,000 (or $220,000 on a joint filed tax return).

ABLE account (529a savings plan)

Created in 2014, the Achieving a Better Life Experience (ABLE) Act allows Americans with disabilities to invest in a tax-deferred savings account.

As with a 529 college savings plan, an ABLE account must be used to pay for qualified expenses. However, this plan goes above and beyond educational expenses — basically, the funds can also go toward disability-related costs such as housing, travel, health care, employment training and more.

The annual contribution limit for 2022 is $16,000 (based on the gift tax amount). This amount can increase by the lesser of either (a) the account holder’s tax-year compensation or (b) $12,880 in the continental United States ($14,820 in Hawaii or $16,090 in Alaska) if the designated beneficiary is currently employed with a source of income.

Contributions can be made by anyone, but they aren’t tax deductible (though certain states will offer tax incentives). The funds never expire and can be used throughout the beneficiary’s lifetime, as long as they’re applied toward qualified expenses.



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