Education savings plans were first created in 1986, when the Michigan Education Trust (MET) established a prepaid tuition plan. More than a decade later, Section 529 was added to the Internal Revenue Code, authorizing tax-free status for qualified tuition programs (also known as 529 plans). Today there are over 100 different 529 plans available to suit a variety of education savings needs.
This article covers the basics of 529 plans, including:
- 529 Plan Tax Benefits
- How to Choose a 529 Plan
- How Much Can I Contribute?
- Will Having a 529 Plan Affect Financial Aid?
- What Are Qualified Education Expenses?
- How to Withdraw from a 529 Plan
- What Happens if My Child Doesn’t Go to College?
- Prepaid Tuition Plans
- How to Open a 529 Plan
529 Plan Tax Benefits
A 529 savings plan works much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds, ETFs and other similar investments. Your investment grows on a tax-deferred basis and can be withdrawn tax-free if the money is used to pay for qualified higher education expenses. Contributions are not deductible from federal income taxes.
You may also qualify for a state tax benefit, depending on where you live. More than 30 states offer state income tax deductions and state tax credits for 529 plan contributions.
Some families use 529 plans as an estate planning vehicle, since contributions are considered completed gifts to the beneficiary. Up to $15,000 per donor, per beneficiary qualifies for the annual gift tax exclusion.
How to Choose a 529 Plan
Nearly every state has at least one 529 plan available, but you’re not limited to using your home state’s plan. Each 529 plan offers investment portfolios tailored to the account owner’s risk tolerance and time horizon. Your account may go up or down in value based on the performance of the investment option you select. It’s important to consider your investment objectives and compare your options before you invest.
How Much Can I Contribute?
There are no annual 529 plan contribution limits, however, there are some important things to consider when making a large contribution. For example, contributions in excess of the annual gift tax exclusion ($15,000 in 2021) will count against your lifetime estate and gift tax exemption ($11.7 million in 2021).
Each state also has an aggregate contribution limit for 529 plans, which ranges from $235,000 to $529,000. This amount is based on the price of attending an expensive college and graduate school program, including textbooks and room and board.
As a general rule of thumb, you can aim to save about one-third of your projected future college costs. This assumes you can cover the remaining two-thirds with current income, including scholarship funds, and student loans.
What happens if I can’t afford the monthly payments?
Most plans allow you to set up automatic recurring deposits from a linked bank account, but it’s not required. After you make a minimum initial contribution requirements (sometimes as low as $25), you can invest as much as you want, whenever you want.
You may choose to make lump sum contributions around birthdays, holidays or other occasions. 529 plans also accept gift contributions from family, friends and other loved ones.
Will Having a 529 Plan Affect Financial Aid?
When a dependent student or one of their parents owns a 529 plan account, there is a minimal impact on the student’s financial aid eligibility compared to other savings accounts, such as an UGMA/UTMA account. Assets held in the 529 plan receive favorable treatment on the Free Application for Federal Student Aid (FAFSA), and distributions are not reported.
However, there may be a greater impact on aid eligibility when a grandparent or other third-party owns the account. In this case, assets are not reported, but distributions used to pay for college are considered cash support to the student. This can reduce the student’s eligibility for need-based aid by as much as 50% of the amount of the distribution.
What are Qualified Education Expenses?
Remember, only qualified withdrawals are tax-free. That means you should only use your 529 plan to pay for qualified educational expenses.
Qualified expenses for college 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.
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.
In recent years, the IRS has expanded the definition of qualified education expenses to include K-12 tuition expenses and student loan repayments. There is a $10,000 annual limit on qualified K-12 withdrawals and a $10,000 lifetime limit on student loan repayments
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.
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 to Withdraw from a 529 Plan
You can use your education savings to pay for college costs at any eligible institution, including more than 6,000 U.S. colleges and universities and more than 400 international schools. For example, you can be a California resident, invest in a Vermont plan and send your student to college in North Carolina.
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 Go to College?
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, the earnings portion of the withdrawal will be subject to federal income tax, and sometimes state income tax.
What happens to money not used in a 529 plan?
If you have leftover money in your 529 plan and you want to avoid paying taxes and a penalty on your earnings, you have a few options, including:
- Change the beneficiary to another qualifying family member
- Hold the funds in the account in case the beneficiary wants to attend grad school later
- Make yourself the beneficiary and further your own education
- Roll over the funds to a 529 ABLE account, a savings account specifically for people living with disabilities
- Since January 1, 2018, parents also have the option to take up to $10,000 in tax-free 529 withdrawals for K-12 tuition
- Since January 1, 2019, qualified distributions from a 529 plan can repay up to $10,000 in student loans per borrower for both the beneficiary and the beneficiary’s siblings
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.
Prepaid Tuition Plans
Prepaid tuition plans are another type of qualified tuition program. 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.
Most prepaid tuition plans are designed to save for an in-state public college, with the exception of Private College 529, which is a prepaid plan sponsored by more than 250 private colleges. Educational institutions can offer a prepaid tuition plan but not a 529 college savings plan.
How to Open a 529 Plan
Opening a college savings plan is easy. You can open a direct-sold 529 plan by completing an application on the plan’s website. Direct-sold plans offer lower fees than advisor-sold plans, but the account owner is responsible for selecting the investments. Advisor-sold 529 plans are only available through licensed financial advisors.