Guide to 529 Plans
July 14, 2021
Guide to 529 Plans
July 14, 2021
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Saving for your children’s or grandchildren’s college education can seem like a daunting task, especially with the skyrocketing costs of higher education. Since 2000, the average annual cost to attend a U.S. college has more than doubled—and it shows no signs of slowing. According to Sallie Mae’s annual How America Pays for College report, American families spent an average of $30,017 on the 2019 – 2020 academic year. How do you capitalize on saving for college (with the added advantage of enjoying some tax benefits)? A 529 plan can be a way to achieve this. CSPN reports that total assets in 529 plans have reached $425.2 billion in 14.83 million 529 savings accounts. Now just may be the time to jump on the bandwagon.
What Is a 529 Plan?
529 plans, legally known as qualified tuition plans, are tax-advantaged savings plans that can be used for college costs and some K–12 expenses. The money in 529 savings accounts grows and can be withdrawn tax-free as long as it’s used for qualified education expenses. According to sec.gov, they “are sponsored by states, state agencies, or educational institutions,” unlike other retirement and investment accounts. A 529 plan falls under either a prepaid tuition plan or education savings plan. They can be used for family members, friends, unborn children, and even yourself. Some 529 plans offer state income tax deductions for qualified contributions, but this varies state to state; for example, California does not offer tax deductions for contributions. Federal tax deductions are unavailable for contributions to these plans. Visit Nerd Wallet’s for an interactive guide to evaluating state 529 plans.
Prepaid Tuition Plan vs. Education Savings Plan
Education savings plans are the more common type of 529 plan used for educational costs. The account holder contributes money to the plan, which is then (typically) invested in mutual funds. The account owner can choose which funds the plan is invested in; as in any mutual fund, the performance varies by the fund, and this performance determines if and how much the account grows over time. Some 529 plans include target-date funds as an option, which adjust the account into more conservative, less risky investments as the beneficiary approaches college-age. These funds can be used at any qualified higher education institution—and may even be used at some non-U.S. institutions.
According to sec.gov, “Education savings plan investments in mutual funds and ETFs are not federally guaranteed, but investments in some principal-protected bank products may be insured by the FDIC. As with most investments, investments in education savings plans may not make any money and could lose some or all of the money invested.”
Prepaid tuition plans are not offered in every state. They vary depending on the state and educational institution, but, in general, they allow you to lock in the current tuition rates for future attendance at specific eligible schools. Like education savings plans, the account balance generally grows over time, and distributions are not taxable. Prepaid tuition plans have one major exception—the funds are not usable for room and board, which is a significant expense for many college students and their parents.
529 Plan Rules
- States sponsor 529 plans – there are no federal tax benefits for 529 contributions
- While you can choose a plan from any state, your state’s plan may be the easiest and best option, as long as it offers a tax deduction for your contributions. 529 plans from other states likely won’t offer you a tax deduction
- Your child/grandchild can use the funds in any state – not just the state where the 529 plan is sponsored
- The account holder owns the funds – you control how much and when the money is spent
- The beneficiary has no control over the account, meaning you can withdraw the funds at any time—likely with taxes and penalties
- The account holder can change the beneficiary at any time
- 529 plans don’t have set contribution limits from the IRS – but do have maximum tax deductions and state-imposed contribution limits
- 529 plans may have a minimum contribution to open the account, but there are no lower contribution limits beyond that. You can contribute as much or as little as you can or want over time
- Your contribution is treated as a gift, and the gift tax may apply if you contribute more than the gift tax exclusion amount
- The five-year front-load rule can be applied here, meaning that you may gift up to five times the annual exclusion amount (currently $15,000/year), totaling a maximum of $75,000 for single or $150,000 for a married couple if no other gifts are made during those five years. If any additional gifts are made, a gift tax form 709 would have to be completed
- The state limits on contribution amounts are generally far higher than anything you’d be likely to contribute (for example, California’s limit for the whole of the account is $529,000)
- Fund distribution rules are strict and specific
- The 529 plan’s funds must be used for qualified education expenses to enjoy tax-free withdrawals. This can include tuition, fees, room and board, textbooks, and general supplies like computers and printers. Since 2019, to repay student loans (up to $10,000) and expenses related to apprenticeships (if registered with the Department of Labor). If the account’s beneficiary receives a scholarship, the funds can be withdrawn up the scholarship amount awarded; however, keep in mind that this exception will be subject to regular income tax but will not incur a penalty.
- Withdrawals on earnings outside the scope of qualified education expenses will be subject to regular income tax and a 10% penalty, while the principal is exempt from penalties.
- If used for K–12 expenses, tax-free withdrawals are limited to $10,000 annually
529 Plans: Fees & Expenses
Fees and expenses vary based on the plan type, state, seller, and the underlying investments. Each plan should supply an offering circular with all the relevant details, restrictions, and fees for your review. Make sure you read this carefully—or enlist the help of a financial and/or tax professional to read the fine print. Prepaid tuition plans may charge enrollment/application fees and/or administration fees. Education savings plans may have more charges as they are invested into mutual funds or exchange-traded funds, including enrollment/application fees, annual account maintenance fees, and ongoing program management and asset management fees.
Many states offer direct-purchase plans. You can invest in this simply by creating an account and depositing the minimum (or more) amount to open the account. This avoids some fees, like the broker-charged fees.
529 Plans & Financial Aid Eligibility
A 529 plan generally will impact a student’s financial aid eligibility, albeit minimal. Parents’ income and assets are considered when determining their child’s financial aid eligibility. Still, assets like 529 plans and retirement funds have much less weight when determining eligibility than their income. Also worth noting: 529 plans held for grandchildren in grandparents’ names are not factored into financial aid eligibility.
It is often advisable to open and hold 529 accounts in a parent or grandparent’s name (or another adult as applicable). A 529 account held in the child’s name is considered their asset when applying for financial aid. It will be factored into eligibility more unfavorably than if it was held in a parent’s name, for example. Qualified distributions from a grandparent’s 529 account are considered income to the student, especially when re-applying for financial aid. Many financial professionals advise to fund the first couple of years of a student’s education from other accounts (a 529 account held by a parent) and then tap into the grandparent-owned plan for the final two years to reduce financial aid implications.
What to Do If You Have Money Left Over in the Account
If you have money left over in the 529 plan, you have several options—maybe the beneficiary doesn’t use all the money for their education, received a substantial scholarship, or choose not to go to college, period. You can change the beneficiary on the account, perhaps to a younger sibling, or keep the current beneficiary should they decide to go/return to school. You can also cash in the remaining balance and pay the taxes and penalties.
A point we regularly harp on: the earlier you start saving, the better. The effects of time and compounding accumulation cannot be understated for any savings or investment accounts. Even small investments early on can build into a large sum of money in 18 years. No matter when you start saving, 529 plans can help you get there—as always, consulting your financial and tax professionals can help you sort through your options and decide what’s suitable for you and your family.
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The college savings plans offered by each state differ significantly in features and benefits. The optimal plan for each investor depends on their objectives and circumstances. An investment in a plan may lose value, and the likelihood of loss is greater if you invest for a shorter period. The investment return and principal value of the investment options are subject to market risk and will fluctuate; when sold, they may be worth more or less than the original cost. Past performance is no indication of future returns. Before investing, it is recommended that investors determine whether their, or a designated beneficiary’s, home state offers any tax or other benefits only available for investments in that state’s qualified tuition program. It is essential to consider each plan’s investment options, fees, and tax implications when comparing plans. As with all tax-related decisions, investors should consult with a trusted financial professional and/or tax advisor before participating in a plan. Typically, 529 plans are not deposits or obligations of, or insured or guaranteed by the Program Manager, any financial institution, certain states or any agency or instrumentality thereof, the U.S. government, or any other federal or state governmental agency or entity or entity person. Plans will offer different investment operations or benefits; not all states will offer 529 Plan options insured by the Federal Deposit Insurance Corporation (FDIC). Please review the complete plan Program Description for further vital details prior to investing.
This blog expresses the author’s views as of the date indicated, are subject to change without notice, and may not be updated. The information contained within is believed to be from reliable sources. However, its accurateness, completeness, and the opinions based thereon by the author are not guaranteed – no responsibility is assumed for omissions or errors. This blog aims to expose you to ideas and financial vehicles that may help you work towards your financial goals. No promises or guarantees are made that you will accomplish such goals. Past performance is no guarantee of future results, and any expected returns or hypothetical projections may not reflect actual future performance or outcomes. All investments involve risk and may lose money. Nothing in this document should be construed as investment, tax, financial, accounting, or legal advice. Each prospective investor must evaluate and investigate any investments considered or any investment strategies or recommendations described herein (including the risks and merits thereof), seek professional advice for their particular circumstances, and inform themselves about the tax or other consequences of any investments or services considered. Investment advisory services are offered through Liberty Wealth Management, LLC (“LWM”), an SEC-registered investment adviser. For additional information on LWM or its investment professionals, please visit www.adviserinfo.sec.gov or contact us directly at 411 30th Street, 2nd Floor, Oakland, CA 94609, T: 510-658-1880, F: 510-658-1886, www.libertygroupllc.com.