Saving for College with a 529 Plan
Benefits of a 529 Plan
Saving for college with a 529 plan provides a variety of federal and state tax benefits. The earnings generated in the account are generally not subject to income taxes, allowing the investments to grow tax-free. And when the funds are used for qualified education expenses, the distributions are also not subject to income taxes.
Many states also offer some form of state income tax deduction or credit for contributions made to a 529 plan. Often, the state's tax benefits are dependent on funding an in-state plan. However some states (Arizona, Kansas, Missouri, Montana and Pennsylvania) offer a tax deduction for contributing to any state plan while others (Indiana, Utah, Vermont) offer a tax credit.
To be eligible for tax-free withdrawals, the funds must be used for qualified expenses at a college, university, vocational school or other eligible post-secondary institution. Those expenses include:
- Tuition and fees
- Books, supplies and equipment
- Room and board
- Computer or peripheral equipment, computer software or Internet access
Types of 529 Plans
There are two versions of the 529 plan to choose from, depending on how you would like to save for college:
- The 529 Savings plan allows families to set aside funds for future college costs. It works much like an IRA, allowing the owner to invest their contributions in mutual funds or similar investment vehicles. The account goes up or down in value based on the performance of the chosen investments. Most plans have a minimum contribution to start, which can be as low as $25 or $50. Then you can choose to contribute small amounts each month or make lump sum payments on your own schedule.
- The 529 Prepaid plan allows you to prepay the average tuition at today's prices and use the credits later at qualifying in-state schools. If your child chooses to attend an out-of-state college, you will not get the benefit of guaranteed tuition. Instead, the plan will pay out an amount equal to the tuition and fees at your state's public institution and the student or parent will be responsible for paying the difference.
Matt Hylland, founder and financial planner at Hylland Capital Management in North Liberty, Iowa, says some families prefer 529 savings plans because they are able to save in small increments, unlike prepaid plans which typically require larger monthly installments.
"Savings plans also have the opportunity to generate higher returns so you will ultimately need to save less to pay for college," he says, compared to prepaid plans. "However, there is more risk in 529 savings plans if they are not invested wisely. If your account is heavily allocated to stocks and the stock market drops, you will likely lose some of your savings."
In that case, your 529 savings plan may not have enough assets to cover all of your child's higher education expenses, and you will have to cover the gaps. Some options include choosing a less expensive school, applying for financial aid and borrowing student loans.
The IRS does not specify a dollar amount for annual contribution limits to 529 plans. However, because 529 plan contributions are considered gifts for tax purposes, large contributions to a 529 plan can trigger a requirement to file a gift tax return.
For 2017, gifts totaling up to $14,000 per individual qualify for the annual gift tax exclusion. This means parents can contribute up to $28,000 per year, per child without gift tax consequences. However, the $14,000 limit also includes non-529 gifts, so any cash or property gifts must be counted in the total.
What if Your Child Doesn't Need 529 Plan Funds?
Generally, when money is withdrawn from a 529 plan and is used for anything other than qualified expenses, the earnings portion of the withdrawal is subject to income taxes and a 10 percent penalty.
However, if your child isn't using the money because they received a scholarship, you can withdraw the amount of the scholarship from the plan without paying the penalty, although you will still have to pay income taxes on the earnings. Then the funds can be used for any purpose you choose.
There is no time limit for taking withdrawals, so you can keep the money in the account in case your child decides to pursue an advanced degree later. Or you can switch the beneficiary of the plan to another eligible family member.
Do 529 Funds Impact Financial Aid?
Uncertainty about how 529 plans affect financial aid makes some parents hesitant to open an account. Hylland says a 529 plan owned by the parent or child will impact financial aid, "but the assets in a 529 plan factor less if the account is owned by the parents with the child as a beneficiary." This is because, for the purposes of calculating the expected family contribution, colleges consider only up to 5.64 percent of parental assets versus 20 percent of assets owned by the child.
Where to Enroll in a 529 Plan
Since plans can differ from state to state, you should research and compare different plans to determine which best fits your needs based on tax incentives, fees and investment options. Depending on the plan you choose, you can enroll directly through your state's 529 plan manager or through a financial advisor.
Did You Know?
We encourage you to consult a financial planner when comparing savings accounts. You can also consult a tax professional for tax advice. Please also see IRS Publication 970 for more information or call the IRS at (TTY ).