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What Is a 529 Plan?

 A 529 plan is an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary. You can use a 529 plan to pay for college, K-12 tuition, apprenticeship programs, and even student loan repayments. If using a 529 plan to save for college, your savings will have a minimal impact on financial aid eligibility.

Types of 529 Plans

There are many types of plans you can choose from in order to save for college but 529 plans are typically categorized as either prepaid tuition or college savings plans. Here is how each of these types of plans works:

  • College savings plans: These 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: These 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.

529 Plan Tax Benefits

A 529 college 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 Your investment grows on a tax-deferred basis and can be withdrawn tax-free if the money is used to pay for qualified higher education expenses.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. These tax benefits make 529 plans better for college savings accounts than traditional savings or investment accounts.

Some families use 529 plans as an estate planning vehicle since contributions are considered completed gifts to the beneficiary. Up to $17,000 per donor, per beneficiary, qualifies for the annual gift tax exclusion in 2023.

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 option  before you invest.

You should choose a 529 plan based on the investment approach you like the best. However, you can still dictate a lot about how your account is invested with many 529 plan providers. There is no benefit or drawback to the state your plan is sponsored in as long as it is a nationwide 529 plan.

The two main things you may want to consider when deciding on your plan are any potential fees and the history of returns from the plan.

How Much Can I Contribute to a 529 Plan?

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 ($17,000 in 2023) will count against your lifetime estate and gift tax exemption ($12.92 million in 2023).

Each state also has an aggregate contribution limit for 529 plans, which ranges from $235,000 to $550,000. 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 monthly contributions?

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 requirement (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.

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 529 accounts. 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.

It’s important to understand that with a 529 plan, only qualified withdrawals are tax-free. That means you should only use your 529 plan to pay for qualified educational expenses. 529 plan withdrawals must happen in the same tax year as the expenses that are incurred. This means that if you’re paying for January expenses you can’t withdrawal funds in December of the previous year, even though it’s only weeks from when you need the money.

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 beyond traditional college costs 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 loans. Another option is to use the savings plan for registered apprenticeship program expenses.

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.

You can use your education savings to pay for college cost 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 Virginia 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 accounts to another third party, such as a landlord.

Remember, you will need to check with your own plan to learn more about how to take distributions from your account. 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 funds they saved in a 529 plan if their child doesnt go t 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 account beneficiary receives a tax-free scholarship
  • The account beneficiary attends a U.S. Military Academy
  • The account beneficiary dies or becomes disabled

However, the earnings portion of the withdrawal will be subject to federal income tax, and sometimes state income tax. The biggest misconception about a 529 plan is that you can never use your funds again, which is simply not true. Also, the taxes and penalties will only be on the portion that you earn in the 529 accounts, not the contributions.

What Happens to Money Not Used in a 529 Plan?

If you have left over 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 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 withdraws 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
  • Beginning in 2024, up to $35,000 of 529 plan assets may be rolled over into  Roth IRA if the plan has been open for at least 15 years.

Remember, you can withdraw leftover funds 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.

While you will not lose funds that are unused, it is important to note that most 529 plan investment options entail market risk and investments in equities and bonds. For risk-averse investors, many 529 plans offer FDIC-insured account options or ‘stable value’ portfolios which offer lower risk, but also lower returns.

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.

Who Can Open a 529 Plan

One of the advantages of 529 plans is that just about anyone can open one. Parents, grandparents, friends, and even students themselves (if they are 18 years old) can open a 529 college savings plan to start a college fund. You can open an account and name a beneficiary who doesn’t even know about it until you want them to use the funds if you desire.

While anyone can open a 529 plan, each plan can only have one beneficiary at a time. You can change beneficiaries down the road if one child doesn’t go to college but another one does, but you can’t name multiple children as beneficiaries at the same time. The beneficiary also does not have to be the owner of the 529 plan and often is not the owner.

Read more related articles here:

Why choose a 529 plan?

Also, read our previous Blogs here:

Can 529 College Savings Plans Be Used Now in Estate Planning?

How Can I Help with My Grandchild’s College Tuition?

Click here to check out our On Demand Video about Estate Planning.

Click here for a short informative video from our own Attorney Bill O’Leary.

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