While it may be fun to ask children what they want to be when they grow up, funding their future education is no laughing matter. With college tuition costs rising approximately 6% each year, it’s never too early to start saving. Although there are many options to help you cover your children’s education expenses, one of the most powerful tools is a 529 college savings plan.
The Wealth Enhancement Group breaks down everything you need to know about 529 plans, from their different types, tax benefits, and expenses they cover, to contribution and withdrawal limits, impact on financial aid, and more.
What is a 529 college savings plan?
A 529 college savings plan is a tax-advantaged investment account designed to help families save for future education costs. Named after Section 529 of the Internal Revenue Code (IRC), these plans can be used to cover a range of eligible expenses at more than 6,000 eligible colleges and universities across the United States – as well as at hundreds of international institutions. As state-sponsored accounts, 529 plans are also available in nearly every state, although their rules vary from location to location. This makes it important to understand which state plan may be right for you.
What are the different types of 529 plans?
There are two main types of 529 plans: prepaid tuition plans and education savings plans.
Prepaid tuition plans allow you to prepay a portion of future education costs at today’s prices to reduce the impact of inflation. However, they have some limitations. First, thanks to state sponsorship, most of these plans require either the account holder or beneficiary to reside within the state. Second, prepaid tuition plans generally cover only college and university fees—not room and board or K-12 educational expenses.
Education savings plans, on the other hand, work more like a Roth IRA or Roth 401(k) in that they allow you to invest after-tax dollars in a range of investments, such as mutual funds and exchange-traded funds (ETFs). , and bank deposit accounts. Some also offer fixed-fund and age-based (or target-date) portfolios that adjust the investment mix based on the age of the beneficiary. Therefore, determining which plan is right for you will depend on the investment options available, your risk tolerance, and the length of time you have to invest.
What are the tax advantages of 529 college savings plans?
One of the most attractive features of 529 plans is their tax advantages. Earnings in these accounts grow tax-free, allowing the value of your investments to rise over time. Withdrawals for qualified education expenses are also tax-deductible, but such withdrawals are limited to $10,000 per year for K-12 expenses. Additionally, some states offer tax deductions or credits for contributions made to their 529 plans, although these tax credits are generally only available to state residents.
What educational expenses do 529 plans cover?
The specific benefits of 529 plans vary by state. You can choose from different state plans, but you’ll need to check with your advisor to make sure you understand the details.
Eligible educational expenses include:
- Tuition and fees for college, university, vocational training programs, or other eligible post-secondary institutions, both in the United States and internationally
- In some states, tuition for K-12 students is up to $10,000 per year per beneficiary
- Room and board for both on-campus and off-campus housing
- Books, school supplies, computers, internet and necessary software
- Campus food and meal plans
- Accessibility of equipment for students with special needs
- Student loan repayment up to $10,000 per student for life
What are the contribution and withdrawal limits?
Unlike some other tax-advantaged accounts such as IRAs, 529 plans have no federal annual contribution limit. Instead, each state sets its own contribution limits, which range between about $235,000 and $530,000. Despite this flexibility, contributions that exceed the annual gift tax exclusion may have tax implications. For 2023, that amount is $17,000 per year per beneficiary in a 529 plan. However, you can “top-fund” a 529 account, meaning you’re allowed to make five years’ worth of gifts in one year. So, instead of gifting up to $17,000, you can actually gift five times that amount, or $85,000.
As mentioned previously, withdrawals must be used for qualified education expenses to avoid taxes and penalties. Additionally, these withdrawals must be made in the same calendar year in which the expenditures are made. This means that you cannot withdraw funds in December of one year to pay tuition fees for January of the following year.
Although you are allowed to withdraw funds for nonqualified expenses whenever you want, such withdrawals will be subject to a 10% federal penalty tax, in addition to any state income taxes applicable to early investment withdrawals. However, there are certain exceptions. For example, there is no penalty for withdrawing funds equal to the amount of scholarship earned or equal to the amount of educational assistance provided to the beneficiary from an employer or as a veteran. These withdrawals will simply be considered regular income and taxed accordingly. Additionally, penalties are waived for beneficiaries who attend a U.S. military academy.
Do 529 plans affect financial aid eligibility?
Many parents are concerned about how 529 plans will affect their children’s eligibility for financial aid. While these plans can impact aid calculations, the impact is relatively minor compared to other assets. This is because these plans are considered parental assets on the Free Application for Federal Student Aid (FAFSA), which generally has less impact on aid calculations than student assets.
At a high level, here’s how it works: The first $10,000 saved in a 529 plan is not at all considered part of the Expected Family Contribution (EFC) account. For amounts over $10,000, a maximum of 5.64% of assets will be included in the FAFSA calculation.
Additionally, when funds are withdrawn from a 529 for qualified expenses, these amounts are not included in the student’s income for financial aid purposes. Until recently, this was only true for parent-owned accounts. However, beginning in 2024-25, distributions made from accounts owned by grandparents or other family members will no longer be reported as student income and will not be included as part of the calculation of financial aid eligibility.
What are the fees and expenses associated with 529 plans?
Like any investment, 529 college savings plans come with fees and expenses. For example, prepaid tuition plans often charge an application fee along with ongoing administrative expenses. Education savings plans generally charge fees for enrollment, annual account maintenance, and program and asset management. In addition, basic fund expenses can include fees such as sales loads or distribution fees.
Because fees can reduce your overall investment returns, it’s important to compare the costs associated with the different state plans you’re considering. Also keep in mind that some states help defray these costs by offering tax benefits or even making matching contributions. So, making an informed decision may require a little research.
What happens to the money left in a 529 account?
There are several reasons why a 529 college savings plan may have money left over. For example, a beneficiary may decide not to attend college or another eligible educational program. They may receive a scholarship that covers their educational costs. Or maybe you’ve simply done a great job of saving and don’t need all the money in your account. No matter the reason, you won’t want to lose access to these funds, so it’s important to understand the portability rules associated with 529 plans.
Although you can always withdraw funds directly, any withdrawals for non-qualified expenses will result in a penalty and are taxable. To avoid these costs, you can:
- Transfer the plan to another family member, such as a child, sibling, parent, or first cousin — or even use the funds for your own education
- Use the funds to repay up to $10,000 in student loans for the beneficiary and the beneficiary’s siblings (this is a lifetime amount, not an annual amount)
- Roll over up to $35,000 to a Roth IRA that has been open for at least 15 years – although this option will only become available from January 2024
What are the pros and cons of 529 plans?
Like any financial decision, a 529 plan has pros and cons.
Benefits of a 529 college savings plan include:
- Tax advantages—such as tax-deferred growth, tax-free withdrawals, and tax-deductible contributions—can provide significant savings over time.
- Flexibility in using funds for various education-related expenses
- High contribution limits and a wide range of investment options tailored to your risk tolerance
- The ability to open an account in the state of your choice, along with potential incentives for residents of certain states
Some disadvantages may include:
- Limited investment options compared to traditional brokerage accounts
- Penalties for ineligible withdrawals
- Restrictions on changing plans or switching investments
This story Produced by Wealth Enhancement Group Reviewed and distributed by Stacker Media.
As a parent, you understand the importance of providing your children with a quality education. With the rising cost of college tuition, it’s never too early to start planning and saving for your children’s future. One of the most popular and advantageous ways to save for college is through a 529 plan. This tax-advantaged investment account is specifically designed to help families save for education expenses and offers a range of benefits. In this article, we will discuss everything you need to know about 529 plans, including how they work, their benefits, and why they are a smart choice for parents looking to save for their children’s college education.