The Ultimate Guide to 529 Plans
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August 24, 2020

What is a 529 Plan?

August 24, 2020

What is a 529 Plan?

History of 529 plans

The first 529 plan was a prepaid tuition plan established by the Michigan Education Trust (MET) in 1986.

529 plans are named after Section 529 of the Internal Revenue Code (IRC), which was added in 1996 to authorize tax-free status for ‘qualified tuition programs’. Earnings in 529 plans accumulate on a tax-deferred basis and distributions are not taxed federally when used for qualified higher education expenses. The definition of qualified higher education expenses was expanded in 2015 to include computers, in 2017 to include up to $10,000 annually in K-12 tuition and in 2019 to include student loan payments and costs of apprenticeship programs.

Can you use a 529 plan for any college?

You can invest in almost any state 529 plan, not just your own state’s 529 plan. 529 plans can be used to pay for college costs at any qualified college nationwide. In most plans, your choice of college is not affected by the state that sponsored your 529 college savings plan. You can be a California resident, invest in a Vermont plan and send your student to college in North Carolina. You can use your 529 plan at more than 6,000 U.S. colleges and universities and more than 400 foreign colleges and universities. Check to see if your institution is eligible under 529 rules.

Which states offer 529 plans?

Nearly every state now has at least one 529 plan available. It’s up to each state to decide whether it will offer a 529 plan (possibly more than one) and what it will look like, meaning 529 plans can differ from state to state. You should research the features and benefits of your plan before you invest, research state 529 plans and even compare 529 plans.

Tax benefits

As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits, such as 5-year gift tax averaging and tax-free qualified distributions. See the top 7 benefits of 529 plans.

Some states offer state income tax incentives to investors as well, such as state income tax deductions and tax credits for contributions to the state’s 529 plan. Research your state’s tax treatment.

Types of 529 plans

529 plans are usually categorized as either prepaid tuition or college savings plans.

  • College Savings Plans work much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds or similar investments. The 529 college savings plan offers several investment options from which to choose. The 529 plan account will go up or down in value based on the performance of the investment options. You can see how each 529 plan’s investment options are performing by reviewing our quarterly 529 plan performance rankings.
  • Prepaid Tuition Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges, sponsored by more than 250 private colleges.

Educational institutions can offer a prepaid tuition plan but not a college savings plan.

What can a 529 plan be used for?

A 529 plan is an investment account that offers tax-free earnings growth and tax-free withdrawals when the funds are used to pay for qualified education expenses. For college, university and other eligible post-secondary educational institutions, this includes tuition, fees, books, supplies, equipment, computers and sometimes room and board. The IRS also allows tax-free withdrawals of up to $10,000 per year, per beneficiary to pay for tuition expenses at private, public and religious K-12 schools.

Tax-free distributions may be used to repay federal and private student loans.

What is not covered by a 529 plan?

The funds in a 529 plan are yours, and you can always withdraw them for any purpose. However, the earnings portion of a non-qualified distribution will be subject to ordinary income taxes and a 10% tax penalty, though there are exceptions.

At the college or post-secondary level, a general rule of thumb is that expenses required for enrollment in an eligible institution are covered. However, there are some costs that you may believe are necessary, but the IRS does not consider a qualified expense. For example, a student’s health insurance and transportation costs are not qualified expenses, unless the college charges them as part of a comprehensive tuition fee or the fee is identified as a fee that is “required for enrollment or attendance” at the college.

Are 529 plan contributions tax-deductible?

Much like a Roth IRA, contributions to a 529 plan are post-tax and are not deductible from federal income taxes. However, over 30 states and the District of Columbia offer state income tax deductions or tax credits for contributions to 529 plans, though you may be restricted to investing in your home state’s 529 plan in order to claim the benefit.

Funds in a 529 plan grow federal tax-free and will not be taxed when the money is withdrawn for qualified education expenses.

What are qualified education expenses for a 529 plan?

Qualified expenses include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access and special needs equipment for students attending a college, university or other eligible post-secondary educational institutions. Transportation costs and health insurance are not considered qualified expenses. The Tax Cuts and Jobs Act of 2017 also allows tax-free distributions of up to $10,000 per year, per beneficiary to pay for K-12 tuition expenses at private, public and religious schools. The SECURE Act of 2019 allows tax-free distributions for student loan repayments up to $10,000 per borrower (lifetime limit) for the beneficiary and the beneficiary’s siblings.

The earnings portion of a non-qualified withdrawal may be subject to federal and state income tax, as well as a 10 percent tax penalty. Since your contributions were made with after-tax money, they will never be taxed or penalized.

Can I use a 529 plan to pay for rent?

Yes, room and board is considered a qualified expense if the student is enrolled at least half-time, which most colleges and universities consider to be at least six credit hours per term.

For on-campus residents, qualified room-and-board expenses cannot exceed the amount charged by the college for room and board. For students living off-campus, qualified room and board expenses are limited to the ‘cost of attendance’ figures provided by the college. Contact your financial aid office for more information.

How do I use my 529 plan?

Once you’re ready to start taking withdrawals from a 529 plan, most plans allow you to distribute the payments directly to the account holder, the beneficiary or the school. Some plans may allow you to make a payment directly from your 529 account to another third party, such as a landlord. Read How to pay your tuition bill with a 529 plan to learn more. Remember, you will need to check with your own plan to learn more about how to take distributions.

Depending on your circumstances, you may need to report contributions to or withdrawals from your 529 plan on your annual tax returns.

What happens if my child doesn’t use the 529 plan?

The future is always uncertain, and some parents worry about losing the money they saved in a 529 plan if their child doesn’t go to college or gets a scholarship. Generally, you will pay income tax and a penalty on the earnings portion of a non-qualified withdrawal, but there are some exceptions. The penalty is waived if:

  • The beneficiary receives a tax-free scholarship
  • The beneficiary attends a U.S. Military Academy
  • The beneficiary dies or becomes disabled

However, your earnings will be subject to federal, and sometimes state, income tax.

What happens to money not used in a 529 plan?

If you want to avoid paying taxes and a penalty on your earnings, you have a few options, including:

Remember, you can withdraw leftover money in a 529 plan for any reason. However, the earnings portion of a non-qualified withdrawal will be subject to taxes and a penalty, unless you qualify for one of the exceptions listed above. If you are contemplating a non-qualified distribution, be aware of the rules and possible tactics for reducing taxes owed.

What happens if I can’t afford the monthly payments?

Most plans have minimum initial contribution requirements (sometimes as low as $25) but after that, it’s up to you. While some families prefer to set up automated monthly deposits because they want to “set it and forget it”, others choose to make lump sum contributions around birthdays, holidays or other occasions. With a 529 college savings plan, you can contribute what you want, when you want.

Related: Top 7 Benefits of 529 Plans

A good place to start:

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