529 plans are designed to help parents set aside money for their children’s college education and even K-12 private school on a tax-free basis. There are two types of 529 plans: 529 college savings plans and 529 prepaid tuition plans. 529 college savings plans are more common. However, a 529 prepaid tuition plan may be a good option in some situations.
Regardless of which 529 plan you choose, you’ll be able to invest your contributions and withdraw them tax-free for qualified education expenses. Also, depending on which state you live in, you may get some extra tax benefits.
Read on to learn more about 529 plans and how to maximize their value.
Types of 529 plans
As previously mentioned, there are two types of 529 plans: the 529 college savings plan and the 529 prepaid tuition plan. Here’s a quick summary of each.
529 college savings plans
This plan is the more common of the two and is offered in all 50 states. Generally speaking, it’s what people are typically referring to when they talk about 529 plans.
A 529 college savings plan is an account to which you can contribute on a regular basis. Over time, you can invest your 529 plan money in various investment funds.
When it comes time to pay for private school or college, you can then withdraw your 529 plan funds to cover certain eligible expenses.
If you withdraw money for other reasons, however, you’ll owe taxes on the withdrawal amount, plus a 10% penalty.
529 prepaid tuition plans
A 529 prepaid tuition plan is exactly what the name suggests. When you save money in one of these plans, you lock in today’s tuition prices for your child’s future.
So, let’s say your local state college charges $10,000 per year in tuition.
If you contribute $40,000 to a 529 prepaid tuition plan, it doesn’t matter how much tuition prices increase. Even if they’ve tripled by the time your child enters college, they’ll be covered for the full four years.
“The advantage is that the kid will have college paid for upon enrollment,” says Sidney Divine, a certified financial planner at Divine Wealth Strategies. “However, it will be a pre-selected college, which doesn’t give the student that many options on college choices.”
In fact, if your child decides to go to school in a different state, you lose the guaranteed value of the plan.
Also, only 22 states offer prepaid tuition plans, 10 of which are closed to new applicants:
Federal tax benefits of a 529 plan
Contributions you make to a 529 plan are deductible from your federal taxes. However, you’re limited in how much you can contribute before you run into the gift tax.
Specifically, you can contribute up to $15,000 per child per year. After that, your contributions would exceed the annual gift tax exclusion amount. Granted, if you’re married, you can double that amount since you and your spouse can each contribute $15,000.
Then, as long as you withdraw the money for qualified education expenses, you won’t have to pay taxes on your earnings.
Qualified expenses include:
- Tuition and fees
- Room and board up to the college’s estimate
- Technology items including computers, printers, laptops, and internet service
- Books and supplies
You can’t use your 529 plan funds to buy a car for transportation, cover your phone plan, repay student loans, or cover your insurance premiums.
“With the new tax law changes, beneficiaries will be able to use funds to pay for private school and not just college,” says Divine.
If you’re using a 529 plan to pay for private elementary through high school, the only qualified expense is tuition – also, there’s a cap of $10,000 per student per year.
State tax benefits of a 529 plan
“Most states with an income tax also offer a state tax deduction up to certain limits for contributors to a 529 plan,” says David Metzger, a certified financial planner at Onyx Wealth Management.
In fact, 27 states and the District of Columbia currently offer tax benefits if you contribute to their state-owned 529 plan. Also, five states offer tax breaks regardless of which state’s plan you use. On the other hand, 18 states don’t offer any tax benefits.
Here’s a rundown of what each state offers:
Best 529 plan for you?
Your state may offer a significant tax benefit that requires you to use their plan to qualify. If that’s the case, your best bet may be to sign up for that 529 plan. Check the table above for details on your state’s 529 plan to get started.
But let’s say you live in a state that doesn’t offer a state tax benefit for 529 plan contributions. Your state may offer a tax deduction or credit regardless of which state’s plan you use. In either of these cases, it’s essential that you shop around.
What if my child doesn’t need my 529 plan funds?
You may not have to pay income taxes and penalties on your 529 plan just because your child chooses not to go to college. If you have another child, for example, you can simply switch the beneficiary.
Also, if your child gets a scholarship, you can withdraw up to the scholarship amount without having to pay the 10% penalty. However, you do have to pay regular income taxes on the withdrawal amount.
The bottom line
Every 529 plan is different. The best 529 plans have low fees and a good selection of funds. New York’s 529 plan, for example, is a good choice – as is Maine’s and California’s. Use an online comparison tool to learn more about each of these
And as you consider a 529 plan for your child’s education, think about your other financial goals as well.
“If a parent has not maximized their retirement savings opportunities, such as an employer-sponsored retirement plan or an IRA contribution, they should consider doing so before funding a 529 plan,” says Metzger.
After all, there are no retirement loans to help you get by.
If you plan to contribute to a 529 plan, make sure you know what benefits you’re getting and find the right plan for your needs. This process can take time, especially if you’re not restricted to your state’s plan. But it’s well worth it.