What is a 529 Plan?
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Summary:
A 529 plan is a government-sponsored savings and investment account that offers significant tax benefits. This plan can only be utilized for what the government considers qualified education expenses. The 529 accounts were devised to help individuals pay for higher education and college tuition. Typically 529 plans will offer tax-free growth and tax-free withdrawals on a federal tax basis, and some states will offer deductions from state taxes as well.
Education is one of the most important things that help shape who we are and what we do in the future. However, in the higher education realm, tuition fees can be exorbitant, particularly if you are sending your child to a private college or an out-of-state public institution.
Public college costs range from around $10,000 for an in-state student to $27,000 a year for an out-of-state student. For those looking to go to a private school, the costs will increase to $32,769 per year. To help families and prospective students cope with these costs over the years, the government introduced federal financial aid and 529 accounts.
529 plans work similarly to Roth 401(k) or Roth IRA plans, where you can contribute funds after paying taxes on them. On a federal level, these plans are allowed to grow tax-free. The catch? 529 plans must be used for qualified education expenses. Keep reading to learn more about what a 529 plan is, what it covers, and how you can use one to pay for your child’s future tuition.
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History of 529 plans
529 accounts, also referred to as qualified tuition programs, are named after section 529 of the Internal Revenue Code. However, 529 plans were originally conceived by state governments. Michigan created the first concept on a state level with a prepaid tuition plan. This plan allowed Michigan residents to start saving for college with significant tax benefits on a state tax level.
The plan proved popular, and in 1996, Congress introduced the plans on a national level through the Small Business and Jobs Protection Act. These plans were originally designed to help families pay for qualified higher education expenses, such as four-year universities. However, in 2017, 529 plans were expanded to cover costs for K-12 public and private schools as well as religious schools. In essence, 529 plans can cover a whole range of education expenses as they are currently structured.
Types of 529 plans
529 plans typically follow two major structures. These are 529 savings plans and 529 prepaid tuition plans. It’s important to understand the intricacies of and differences between these two plans.
Prepaid plans
Prepaid tuition plans are structured exactly how they sound. The plan holder, essentially, “pre-pays” for tuition that will be due in the future. At in-state institutions, 529 account holders may partially or fully prepay the tuition, which account owners can then convert to fund an out-of-state or private university. There are currently 10 states that offer prepaid tuition plans under the 529 umbrella: Florida, Illinois, Maryland, Massachusetts, Michigan, Nevada, Pennsylvania, Texas, Virginia, and Washington.
Prepaid plans are particularly beneficial if you believe that college costs will increase, which they probably will. This is because the prepaid plan allows you to lock in the tuition costs at the current rate based on the state’s qualified tuition program.
For instance, say you’re contributing to your child’s plan to go to the University of Texas, which will ideally occur ten years from now. You’ll start prepaying the tuition based on what the tuition rate is today, not ten years from now. This allows you to lock in the price. Some educational institutions may offer a prepaid tuition plan directly, but do not have general savings plans.
Savings plans
529 college savings plans are the most commonly used 529 plans, and they work very similar to Roth 401(k) or Roth IRA plans. As with these accounts, you must pay tax on the money before you contribute to your 529 account. Once contributed, the money can grow tax-free. In addition to growing tax-free, you can also withdraw this money tax-free as long as the funds pay for qualified education expenses.
Depending on the state, you might also be able to receive tax advantages such as deductions on a state income tax level as well. Regardless of your investment objectives, there is probably a 529 plan which suits your appetite.
A 529 college savings plan can have only one beneficiary. However, you can use multiple 529 plans in multiple states. All of these plans will have the same federal tax benefits. That being said, you might only be able to receive deductions from state income taxes if you currently reside in a state that offers them. Regardless of the state and asset allocation plan, these must be used for qualified education expenses.
Looking to start saving outside of the 529 umbrella? You could start an investment account at a brokerage (or with an investment advisor) and earmark it for education expenses. You won’t get the tax benefits but you do get the flexibility of being able to use the money for whatever you want.
Alternatively, you could simply open a traditional savings account. Here are some good options to choose from.
Qualified educational expenses
Qualified education expenses are educational costs that you can pay using the funds from a 529 plan. This means that they are related in some way, shape, or form to education. As of 2017, these qualified expenses include education costs for the following schools:
- K-12. As of 2017, 529 plans can now fund K-12 education expenses. These can be at a normal public/private institution or a religious school. However, you can only use a 529 plan to pay for up to $10,000 of tuition costs for a K-12 program.
- Four-year college. 529 plans are mostly used for a four-year college. What’s great about 529 plans is they can be used not only for the tuition associated with the school but the room, board, and various expenses associated with it. This even applies to any food or equipment costs a student may need to purchase in relation to their field of study.
- Graduate school. Graduate schools also qualify under the 529 investment plans. If you’re currently enrolled in college and still have a bunch of money in your 529 accounts, applying to grad school can be more attractive from a financial perspective. This is because the 529 account can only be used for education, and if you run out of education, you run out of uses for the money.
- Vocational school. 529 plans can also be used for vocational schools. If you want to take a two-year vocational course in IT and computer maintenance, 529 plans will cover it.
In addition to tuition, books, housing, and food costs associated with higher education institutions, students can also use 529 plan funds to make student loan repayments. However, it should be noted that these payments are limited to a lifetime cap of $10,000.
| Expense | College, Trade & Graduate Schools | K-12 |
|---|---|---|
| Tuition | Full. There is no limit to contributions towards tuition from a 529. | Up to $10,000 |
| Rent and Lodging | Yes, applicable to all rent and lodging in a college or higher education environment. The beneficiary must be enrolled half the time. | No |
| Books and School Supplies | All books and school supplies in university or college constitute a qualified expense. | No |
| Transportation | No | No |
| Computers and Tech | Yes, all computer and educational tech-related expenses are considered qualified under college rules. A computer can be purchased for education purposes for K-12 | No |
| Medical Insurance | No | No |
| Intermural/Afterschool Sports or Programs | No | No |
| Special Needs Items | Yes, special needs items are eligible expenses for college. | No |
| Student Loans | Yes, loans are covered with a lifetime cap of $10,000 | N/A |
| Tutoring | Yes | No |
| Business Purchases | Yes, some business purchases can be used by the student if it is related to their college degree before they leave. | No |
529 plans and federal student aid
Federal student aid is aid that is given to students at a low-interest rate to be used for the purposes of education. These funds are implicitly backed by the federal government, hence the low-interest rate. They are usually accessed by using the Free Application for Student Aid (FAFSA).
Many people will want to take advantage of all methods to pay for college, including scholarship funds, 529 plans, and student aid. Luckily, when using FAFSA in conjunction with 529s, the government understands the contradiction of encouraging people to save for college yet having it affect their aid eligibility.
Because of this, FAFSA caps the 529 plans at 5.64% of total assets. This means that regardless of the value of your 529 plan, it can only represent a maximum of 5.64% of your assets when the government is reviewing your ability to pay for college.
Pro Tip
For those looking to send multiple kids to college and save a lot of money, there are several states that offer significant state tax deductions for 529 plans. It might be wise to consider relocating to a state that offers good schools and tax deductions.
Tax benefits and 529 plans
529 plans can also have advantages for people looking to pass on wealth to future generations or general friends of the family and well-wishers. The federal government will treat a 529 plan as any other gift; thus, you are required to pay gift tax on it.
Luckily there’s an exclusion for these types of taxes. The annual gift tax exclusion is $16,000. This means that a grandfather or grandmother can contribute $16,000 to a 529 plan every year, without paying taxes on it.
Along with the annual gift tax exclusion, there also exists a lifetime gift tax exclusion. Currently, this exclusion sits at $12.06 million. If you give more than the annual limit of $16,000 in a year, the excess will be counted against your lifetime exclusion of $12.06 million. This allows non-direct family members to contribute to a beneficiary’s education, as well as save on taxes.
Who can open a 529 account?
Anyone can open a 529 plan, but a 529 plan can only have one beneficiary on the plan. For example, you might open two 529 plans for one child, one in the state you live in and one whose 529 plan aligns more with your investment objections.
A non-immediate family member or general well-wisher can also open a 529 plan. However, the plans can still only have one beneficiary. That being said, if you have multiple children, you can also transfer an existing 529 plan to another beneficiary.
Leftover 529 plan funds
Though rarely the case, some beneficiaries leave college with money still in their 529 accounts. Because the money must be used for qualified education expenses, you may be limited to what you can do with this money.
- Transfer the beneficiary. If you have money left over in an initial 529 plan, you can transfer the leftover funds to another beneficiary. This is most commonly a younger child in the immediate family.
- Go back to school. An adult whose child has graduated from a college or university can sometimes be left with some residual 529 money. 529 plans can be used for full-grown adults who go back to school to help pay their qualified education expenses.
- Pay taxes. Unfortunately, if you have no other options to use the 529 funds for education expenses, you need to pay taxes and fees to retrieve the money out of the plan. Since this also includes federal income tax, it’s important to plan exactly how much money you will need in the future.
FAQs
Can I use a 529 plan to pay for rent?
Yes, you can use a 529 account to pay for room and board at a college or university.
What happens if my child doesn’t go to college?
If your child doesn’t go to college, you have three choices. You can transfer the beneficiary to someone else (like your niece), you can go to school yourself, or you can bite the bullet and get charged taxes and fees. If your child goes to a vocational school, however, they can still use a 529 plan.
Can you lose money in a 529 plan?
Yes, like all investment plans, it’s possible to lose money. However, it’s important to note that most 529 plans are pretty safe investments, such as mutual funds.
Who maintains control over a 529 plan?
A 529 plan typically has a custodian who maintains custodial control over the plan as the account owner.
Key Takeaways
- 529 accounts are government-sponsored plans that offer significant tax advantages.
- Similar to a Roth IRA or 401(k), a 529 plan allows you to grow and withdraw your money free from federal income taxes. They also offer state tax deductions based on the state in which you reside.
- To be exempt from these state and federal taxes, 529 plans must be used for qualified education expenses. Qualified expenses include tuition costs for K-12, four-year colleges, and vocational schools.
- The two major types of 529 plans are prepaid tuition plans and savings plans.
- 529 plans can be a smart way to use the annual gift tax exclusion, provided the contribution is under $16,000 a year.
- Anyone can open a 529 account, but it can only have one beneficiary.
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