What Is a 529 Plan?
Discover how a 529 savings plan can help you put away and invest money for your children’s college tuition.
Many parents dream of seeing their child experience and complete a college education. But as anyone knows, getting a degree is expensive, often needing years of saving. However, it can be hard to know what that looks like, especially far into the future. While the ultimate amount varies, it often ends up in the ballpark of $100,000 per child. One way to begin saving for your child’s education is by setting up an education fund, such as a 529 plan.
Creating a 529 account allows you to save and invest money tax-free for qualified college tuition, as well as K-12 education. In this article, we’ll explain in-depth how these plans work and whether you need one. We’ll also lay out some benefits and disadvantages of setting one up.
How 529 Plans Work
A 529 plan, also known as a qualified tuition plan, is a tax-advantaged account that allows you to save for college expenses. With these accounts, you contribute funds on a tax-deferred basis for the later benefit of beneficiaries, often children, you designate.
If you’re paying for qualified expenses, you don’t have to pay income taxes when you withdraw money from a 529 account. However, if you take money out for unqualified tuition or non-educational purposes, you’ll have to pay a 10% penalty tax. Typical education costs that qualify include:
- College tuition (includes room and board, books, computers, and fees required by the institution)
- K-12 education
- Student loan repayment
- Apprenticeship program
Within your account, you’ll have the option of investing. You’ll often be able to select from a specific set of investments. This may include actively managed mutual funds, index funds, or exchange-traded funds (ETFs). Though, this can vary from plan to plan.
529 plans offer a great deal of flexibility. One way, for example, is with beneficiary changes. If one of your kids chooses not to attend college, it’s easy to remove them as a beneficiary or name someone else. These accounts are also accommodating with who can contribute. Family members can also set money aside within the account if they would like to help with your kids’ education.
Regarding taxes, the main advantage 529 plans carry is that they’re tax-deferred and allow you to withdraw tax-free when you’re paying for specific qualified expenses. This means that tax payments won’t eat into the money you’ve likely saved for a long time for your child to go to school.
Because the account is tax-deferred, you also won’t need to pay taxes on income from investments. This means, for example, if you earned dividends within the account from a mutual fund, you wouldn’t need to pay taxes on it.
These plans also have tax benefits on gift contributions. That is, donations less than or equal to $17,000 from one person or $34,000 for married couples in one year won’t trigger an annual gift tax.
Prepaid Tuition Plans vs. Education Savings Plans
There are two primary types of 529 plans — prepaid tuition and education savings. Though both share the quality of enabling you to save for education, they vary in several ways. This includes how you pay and which types of institutions qualify. Here are the distinctions between the two:
- Education savings plans allow you the freedom to grow the funds you put in through various types of investments. Beneficiaries can also use money from these plans at any public or private university or college. Account proceeds can fund up to $10,000 of tuition per year.
- Prepaid tuition plans have some more constraints than their counterparts. With these, you purchase tuition units or credits ahead of time. The main benefit of this is that you get to pay pre-determined rates and, potentially, avoid increased tuition costs due to inflation in the future. However, these plans require a student to attend an in-state public university and don’t usually cover K-12 education or lodging and books in college.
Who Needs a 529 Plan
529 plans are among the most effective college saving vehicles. Specifically, they’re great if you envision sending a child to an educational institution, such as a university, trade school, or private school, and want to ensure you have enough to cover costs in the future. Depending on the plan you select, you may be able to use your account to fund elementary, high school, and university tuition costs.
Because these plans allow for plenty of flexibility in who can be a beneficiary or account owner, they’re also a good choice for family members, friends, or other interested parties who want to help someone earn a post-secondary education.
As with a retirement account, such as a 401(k) or Roth IRA, an advantage of creating a 529 is the ability to consistently contribute while also seeing growth from compound interest and investments. If you’re able, setting up a contribution schedule or receiving money from outside sources can enable you to put together a nice nest egg for your child’s education.
Setting Up a 529 Plan
Establishing a 529 plan is often an easy process. However, you have a couple of options. You can either do it through your state or with the help of a professional, such as a financial advisor. When you open one through your state, this is called a “direct-sold 529 plan.” With these, you’ll undertake the responsibility of assigning beneficiaries and selecting relevant investments.
Conversely, buying through an advisory professional or organization is known as an “advisor-sold 529 plan.” If you take this route, you’ll pay the company or individual a higher fee to take care of the administrative aspects of the account, including the management of its assets.
529 Plans by State
States often back a unique 529 education savings plan to encourage people to save for their children’s post-secondary academic costs. You’re free to create an account in any state. This is even the case if you don’t live there. Even so, it’s important to note that some states offer special advantages, such as tax benefits, to in-state participants of savings programs.
Below is a table that lists each state’s sponsored savings plan:
Pros and Cons
529s are valuable because of their tax advantages and overall flexibility, especially regarding who can pay into them and be a beneficiary. But they also have their downsides, including fees and a restricted set of investment choices. If you’re on the fence, consider meeting with a financial advisor to see if one of these plans is right for you.
To get a quick picture of 529 plans, here is a list of their pros and cons:
- Tax benefits. 529 accounts are tax-deferred and can bypass taxes if the withdrawals go towards qualified tuition and related expenses, such as living arrangements, mandatory fees, and computers.
- Investing. Account owners can choose investments and grow money for beneficiaries.
- Compound interest growth. These accounts have compound interest, which leads to additional growth.
- Flexible contributions. Anybody (not just the account owner) can contribute money if they want to.
- Beneficiary flexibility. You can easily add or remove beneficiaries. This is helpful if one of your children, for instance, chooses not to attend college.
- Limited investments. While these plans often include securities such as mutual funds and ETFs, you may not have the same breadth of options you would have with a brokerage account or Roth IRA.
- Fees. These can depend on your plan; however, you may face enrollment costs and operational fees. If you invest within the account, there’s also a good chance of paying expense ratio fees.
- Unqualified expenses incur penalties. Withdrawals for anything other than qualified expenses incur a 10% tax penalty.
- Investment risk. Investments always have a certain level of risk. If the ones in your account suffer losses, the fund could lose some of its value.
Frequently Asked Questions
What if my child doesn’t go to college?
If you have money saved in a 529 but one or more of your kids doesn’t attend a higher education program, you have some options. You can designate alternative beneficiaries, including other young family members or other children. Another strategy is withdrawing the money from the account. But keep in mind that this will incur a 10% penalty.
Who can contribute to a 529 account?
Anyone who wants to support someone’s education can contribute. The most common party to contribute (and be the account owner) would be a child’s parents, but this can also include:
Do 529 plans affect financial aid?
They can impact financial aid in a small capacity, but only if parents own the account. This is because 529s if owned by a parent with a child as a beneficiary, are classified as parental assets. When a student completes a Free Application for Federal Student Aid (FAFSA), only 5.64% of the funds belonging to their parents, including those within the plan, count toward the amount they’re likely to put toward college expenses for a school year.
If someone else owns the account, such as a grandparent, it doesn’t count as a parental asset. Therefore, it won’t have any bearing on government financial aid.
What don’t 529 plans cover?
Not all academic expenses fall within the qualified costs a 529 can cover without penalty. Here are some common ones:
- Student loans
- Transportation (i.e., gas, car depreciation, auto insurance, etc.)
- Campus parking fees
- Application costs
- Club and activities (i.e., fraternities, sororities, sports, etc.)
- Health insurance
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