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7 ways to maximize your 529 plan to help pay for college

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A 529 plan is a great option for families looking to save money for their child’s education. With overall prices and cost of living rising so fast, it’s more important than ever to plan your finances carefully.

529 plans are state-sponsored and allow you to use after-tax contributions to grow earnings on a tax-deferred basis. You’re permitted to join the plan offered by any state, but yours might have unique benefits or additional state tax breaks for residents.

You can withdraw the funds for qualified educational expenses, including tuition, fees, and textbooks without having to pay taxes. With a 529 education savings plan, families can open an account and then invest their money in high-growth assets such as stocks.

It’s one of the best ways to save for education expenses, which makes it so surprising that 529 plans are relatively underused.

While 529 plans can ease the rising burden, it’s absolutely critical to follow the rules of the plan, or you’ll otherwise face some strict penalties. Here’s how experts say you can make the most of your 529 plan.

1. Start early to invest aggressively

One of the biggest advantages for 529 plan participants is time, so it’s important to make wise use of it. That’s because time gives you the advantage of compounding, letting your money earn money in a virtuous cycle. And time also allows you to invest more aggressively.

“The earlier a 529 is established, the more risk it can take, hopefully maximizing the tax-free growth,” says Andrew Aran, a partner at Regency Wealth Management. He says that this extra time allows investors to take more chances with stocks, where the longer-term return is higher but the short-term return can be volatile.

But there are a lot of variables in figuring out how exactly to structure your plan, says Skip Johnson, partner at Gratūs Funds.

“You need to know the time horizon of when the funds will be needed, the amount you will need to save in a 529 plan by the time college comes around, and the level of risk you are taking on the investments will likely change as you are getting closer to needing the funds,” says Johnson. “This is where an advisor can help you.”

And even if you don’t want to manage the portfolio yourself or hire an advisor to do it, you can often take advantage of funds that adjust the risk automatically.

“More-conservative investors will choose a target-date strategy that automatically reduces the equity allocation as the college years get closer,” says Aran. With a lower allocation to stocks as the student nears college, the 529 plan becomes less risky.

But the key is to start early, even with just a little bit of money.

“The minimum amount required to open a 529 account varies, but many 529 plans require as little as $25,” says Rick Castellano, a spokesperson for student loan provider Sallie Mae. “Some plans offer even lower minimums if you enroll in direct deposit.”

2. Get extended family involved

While the primary burden of paying for college usually falls on parents or students, 529 plans also offer the ability for extended family members to play a role in sending their relatives to college.

That’s because relatives can contribute to these accounts or even open one themselves, a fact that many experts point out. So that’s a great opportunity for a child’s larger family to contribute. And regardless of your relation to the future student, you can take a deduction for contributing to their 529 plan.

For example, if you’re a grandparent, you can contribute to the plan and can take a deduction on your state’s taxes if your state offers such a deduction. In some states, you don’t even have to be the owner in order to claim the deduction, though in others you must be. So, you’ll want to check out your state’s rules for 529 plans before you begin.

3. Watch the rules closely

A 529 plan allows you to withdraw money for qualified expenses without tax or penalty. But the emphasis here is on the word qualified. Withdraw more for the year than you’re allowed and you could be assessed a penalty or taxes.

“It is key that you do not withdraw more from the 529 plan than the actual expenses you have incurred in a given year,” says Lawrence Sprung, certified financial planner and president at Mitlin Financial.

Sprung gives an example of a student with $30,000 annual tuition. You might be tempted to take out the full amount from the 529 plan at the start of the school year, but that could create a problem.

“Being that the first semester starts in August, and you will only incur the $15,000 expense in the current year, you would not want to withdraw the total $30,000 as the additional $15,000 may become taxable because of it,” says Sprung.

While that seems like a small detail, it’s important in avoiding a financial assessment that could otherwise go to funding your student’s education.

4. Pay the school directly

One way to help ensure you avoid small snafus like withdrawing too much is by having the 529 plan pay the school and cut yourself out of the process. It can also offer peace of mind.

“The best way to use the funds is to have the 529 plan pay the college cost directly to the school,” says Sprung. “This ensures that you are not taking out more than your expenses, as this could cause a tax liability.”

So set up a direct payment process with your 529 plan and sleep a little easier.

5. Know your state’s 529 rules

States set the rules for their own 529 plans, so it’s important to understand the benefits and drawbacks for the state where you establish your plan. States put restrictions on various facets of the program, and it’s up to you to figure out what they are.

“Every state sets a maximum account balance, and if your 529 reaches that limit, whether through contributions, investment growth or both, you won’t be allowed to make any more contributions to it,” says Corbin Blackwell, a certified financial planner at Betterment.

Blackwell notes that savers should be sure to claim any available state income tax deductions.

Those tax breaks will vary by state and may come in the form of deductions or credits, too. However, some states don’t offer any tax break at all, or offer it only if you’re contributing to your home state’s 529 plan. Still, some states offer a break for contributions to any 529 plan.

6. Take advantage of additional tax benefits

While 529 plans can be a great tool, don’t forget to use them in combination with other tax benefits in order to maximize the whole package.

For example, the American Opportunity Tax Credit can provide up to a $2,500 tax credit annually when paying for qualifying education expenses – a 100 percent credit for the first $2,000 spent and a 25 percent credit for the next $2,000 spent.

“The expenses must be paid directly, which means using 529 funds do not qualify,” says Dejan Ilijevski, investment advisor at Sabela Capital Markets. “If your 529 savings will not cover all four years of college… then spread out the distributions and pay $4,000 out of pocket each year. That would qualify you for a total of $10,000 in tax credits.”

“There are income limits, but most families are eligible,” says Ilijevski. “Don’t leave it on the table, it’s free money that should be a part of every college plan.”

7. If one child doesn’t use it, another might

Parents often worry that they may tie up their money in a 529 plan if the designated child doesn’t go to college or is otherwise unable to use the full amount in the account. Or they may fear that they’ll lose all the money accumulated in the account.

“You don’t lose the money in a 529 if you don’t spend it all. You can change the beneficiary to a sibling, grandchild, niece, nephew, or other relative,” says Castellano.

And if you can’t re-designate the money in the 529 plan, then you’ll have to withdraw the money and may have to pay a penalty and income tax on the account’s earnings. But you won’t lose the entire value of the account.

And don’t overlook who might be eligible to use the funds. The Tax Cuts and Jobs Act of 2017 permitted 529 plans to also be used for educational expenses of private elementary and high school education, too. So there are many alternatives for using the money if one child does not attend college.

Bottom line

The 529 plan can be a boon for parents looking to fund their child’s education, but working your way through the sometimes-complex plan rules can be tough. Yet some of the best advice is also the simplest – start early to give the account the most time to accumulate money. That strategy also gives you the possibility to invest more aggressively, generating an even higher return.

Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
Edited by
Senior wealth editor