A 529 plan is a tax-advantaged savings plan that allows you to pay for education expenses.
This college savings plan allows any contributions to the account to grow tax-deferred. Money can be withdrawn tax-free as long as it’s used for qualified education expenses, such as tuition and fees, room and board and books at universities as well as technical and vocational schools. While created to help pay for college, these plans can now also be used to pay for K-12 tuition at private schools.
A 529 plan may even reduce your taxes today. More than 30 states and the District of Columbia offer some form of tax reduction for the plans, according to Savingforcollege.com. Contributions are made with after-tax money, so they won’t earn you any federal tax deduction, however.
Here’s what you need to know about 529 plans and how to use them to achieve your future college savings goals for your children.
How 529 plans work
A 529 plan allows a participant to set up a tax-advantaged account to allow a beneficiary to use the funds for qualified education expenses. The participant deposits after-tax money in the account. The money in the account can grow tax-deferred and then be tapped tax-free for relevant expenses.
Anyone can establish a plan and contribute to it. Parents, grandparents and other relatives can all open and contribute to the account and get a tax benefit from doing so. You can even fund your own educational expenses this way. You might not even have to be the owner of the account to claim a tax deduction for your contribution, though it depends on the state’s laws.
If your child opts not to go to college or other vocational school, the beneficiary can be changed to another family member who might be able to use the money. In general, the plan can continue holding the funds indefinitely as long as it has a living beneficiary listed.
However, eventually if the money can’t be used, it must be withdrawn. Then, you’ll have to pay taxes on the earnings, as well as a 10 percent penalty.
When you withdraw the money from your 529 plan, you will want to use it on education expenses in that same calendar year. Otherwise, you’ll be making an unqualified withdrawal that will cause the IRS to take notice, since you won’t be using the funds. Be sure to keep any receipts, should the IRS come calling.
Finally, some states’ plans are better than others, and it can pay to look around and find the best plan for you. You’ll want to look for low cost, good investment returns and good benefits. The rules for each state plan differ, so you’ll need to know the specific rules for your plan.
What are the different types of 529 plans?
The 529 plan has two major types: a prepaid tuition plan and an education savings plan. They each serve different needs and offer different investment methods.
A prepaid tuition plan lets you buy college tuition credits to use in the future at today’s prices. A 529 participant can purchase these credits only at participating colleges and universities for the plan’s beneficiary. These credits can’t be used for room and board and aren’t available for primary and secondary schools.
An education savings plan is more encompassing and it allows you to open an investment account that can be tapped in the future for education expenses. These plans pay for tuition and fees, room and board, books and other qualified costs. This account can generally be used at almost any U.S. college or university and can also be used for K-12 private education.
The education savings account can be invested in many different assets including potentially high-return options such as stock funds, as well as lower-return but less risky options such as bond funds and even money market funds. However, if it’s invested in the market such as in stock funds or bond funds, its value is not insured by state or federal governments. Note that some investments, such as money market accounts, may be protected by the FDIC.
Tax and financial aid benefits
The 529 plan can offer several tax and financial aid benefits to participants.
First and perhaps most important, a 529 plan permits you to grow your contributions on a tax-deferred basis. In other words, you won’t pay taxes on any earnings in the account, so long as you maintain the money in the account.
Another key benefit of the plan is that when it comes time to use that money for education, you can take out the money and use it without paying tax on the gains. In effect, your tax-deferred gains become tax-free gains, if you use the money for qualified education expenses.
Participants can benefit further if they live in a state that offers a tax deduction or credit for contributions to a 529 plan. That offers yet another avenue to save on taxes. However, you won’t get a state tax deduction for a state where you don’t pay taxes.
A 529 plan can have only one beneficiary at a time, but this beneficiary can change over time. So a 529 plan can work for multiple kids, if they don’t need to use the program at the same time, but you’ll want to plan ahead to avoid potentially violating a plan’s rules.
For example, if your children’s ages are more than four years apart, you may be able to change the plan’s beneficiary after the first child graduates. If you do this, however, you might want to factor in how much money is left in the plan for the second (or third) child once it’s been tapped by an earlier child.
Moreover, using just one plan may make the 529 plan less valuable for later children. For example, if you switch to more conservative investments as the first child nears college, then it may deprive the second child of potential future returns from more aggressive investments depending on how it’s allocated.
That’s why it may make more sense to have a separate 529 plan for each child. In addition, this approach allows you to keep better records and may offer you an additional chance for a state tax deduction if your state offers one.
At the end of 2019, Congress authorized funds in a 529 to be used for loan repayment. Up to a total of $10,000 can be used to pay back student loans, and as much as another $10,000 can be used to pay loans for a beneficiary’s siblings.
What is covered by a 529 plan?
It’s important to understand that you can only access your money on a tax-free basis if you spend it on qualified education expenses. Anything that doesn’t fit the IRS’s interpretation of a qualified expense will likely see the agency slapping a penalty on your withdrawal. A student must be enrolled at least half-time and the expense must be required by the school.
For colleges and other post-secondary institutions, a qualified expense includes tuition, fees charged by the institution and textbooks. You can also use funds for room and board as well as computers and software that are used primarily for educational purposes.
If you’re using a 529 plan for K-12 private education, your qualified expenses are much more limited. In this case, you’ll be able to use the funds without penalty only for tuition. The law also limits a maximum payout of $10,000 annually without incurring a penalty.
In addition, the plan allows funds to be used for expenses for special needs services, provided that they are incurred as part of attendance at the school.
Following a 2019 change, a 529 plan can also be used to pay for an apprenticeship as long as the program is registered with the U.S. Department of Labor.
What is not covered?
In short, anything else that is not specified by the IRS in its definition of a qualified expense is likely not covered. Again, the IRS specifies that qualified expenses must be “related to enrollment or attendance at an eligible post-secondary school.” Moreover, the IRS says that “to be qualified, some of the expenses must be required by the school and some must be incurred by students who are enrolled at least half-time.”
But you will not be able to use a 529 to pay for transportation costs at college or other extracurricular fees. And a 529 plan works only for eligible schools, in practice almost any reputable institution, so it won’t offer any advantage for other schools.
How to start a 529 plan
If you’re looking to open a 529 plan, you can do that directly through a state’s plan. But you also have the option of going through a broker or financial adviser who may be able to assist you with the plan. However, this latter approach will cost you more money.
If you want to go directly to the state plan’s website, you’ll need to register, analyze the potential investments and then manage the plan over its lifetime. You’ll be overseeing the plan and dealing with any issues that arise.
If you work with a broker or financial adviser, you can have your agent do the heavy lifting: finding the best state plan for you, selecting the funds and overseeing the program. A broker or adviser may also be able to give you further advice on the program. But you’ll pay for this extra level of service with either a sales commission or higher investment fees.
Where did 529 savings plans originate?
The 529 plan originated in 1996 and took its name after Section 529 in the Internal Revenue Code, which authorized qualified tuition programs to provide tax-free benefits to savers. The plan has its origins in Michigan’s 1986 decision to offer prepaid tuition plans to state colleges.
What counts as a qualified expense has expanded over the years. In 2015, the plan began to include computers as a tax-free expenditure, while 2017 saw the program include K-12 tuition of up to $10,000 annually. In 2019, the plan expanded further to include loan repayment, mentioned above, as well as the option to use a 529 plan to pay for apprenticeship programs.