A 529 plan is a tax-free way of saving for college costs. Money in 529 college savings plans also has a minimal impact on the student’s eligibility for need-based financial aid for college. Since 2018, 529 plans can also be used to save for elementary and secondary school tuition.
Tax Advantages of 529 Plans
529 plans are named after section 529 of the Internal Revenue Code of 1986. 529 plans are similar to a Roth IRA, in that contributions are made with after-tax dollars, but have several additional advantages.
Superfunding a 529 plan, also known as 5-year gift-tax averaging, allows lump-sum contributions that are as much as five times the annual gift tax exclusion, without incurring gift taxes or using up part of the lifetime gift tax exclusion. Contributions that exceed the annual gift tax exclusion are treated as occurringproportionately over a five-year period.
Earnings in a 529 plan accumulate on a tax-deferred basis and are entirely tax-free if used to pay for qualified higher education expenses. More than two-thirds of the states provide a state income tax deduction or tax credit on contributions to the state’s 529 plans.
The earnings portion of a non-qualified distribution is taxable at the beneficiary’s rate, plus a 10% tax penalty. The non-qualified distribution may also be subject to recapture of state income tax benefits previously received.
As an alternative to a non-qualified distribution from a 529 plan, the account owner can change the beneficiary, use the 529 plan to pay for graduate school, or keep the money in the 529 plan account for future grandchildren. There is no time limit on when 529 plan money must be used.
What Expenses are Qualified Expenses?
Qualified higher education expenses include tuition, fees, books, supplies, equipment, special needs expenses and computer-related expenses at an eligible higher education institution. Qualified higher education expenses also include room and board if the student is enrolled on at least a half-time basis.
Eligible higher education institutions include all colleges and universities that are eligible for Title IV federal student aid. Such colleges and universities include more than 400 foreign colleges and more than 6,000 U.S. institutions.
Qualified higher education expenses do not include transportation, dependent care costs, health insurance and miscellaneous/personal expenses. Student loan payments are not currently considered to be a qualified expense.
Qualified expenses include up to $10,000/year per beneficiary in private K-12 tuition costs.
How to Find a 529 College Savings Plan
Almost every state offers at least one 529 college savings plan. You can invest in any state’s 529 plan, not just your own state’s plan. The main considerations when choosing a 529 plan include the 529 plan’s performance, fees and state income tax benefits.
There are two main types of 529 plans:
- Direct-sold 529 plans, where the family invests directly with the state.
- Advisor-sold 529 plans, where the family invests through a financial advisor.
Generally, direct-sold 529 plans charge lower fees than advisor-sold plans.
Savingforcollege.com provides several resources for finding a 529 plan, including a 529 plan comparison tool, quarterly performance rankings and 5-cap ratings, an annual fee study, and annual lists of the best 529 plans.