Saving for your child’s college education? A 529 plan can help

What is a 529 plan?

A 529 plan, often called an education savings plan, is a savings and investment account that offers tax benefits to individuals who want to save for the education of any immediate family member. The 529 comes from the section in the Internal Revenue Code that addresses education savings accounts and their tax benefits.

A 529 plan has historically been referred to as a college savings plan because, until recently, the funds had to be used to pay for college or graduate school expenses to receive favorable tax treatment. Today, it is more widely known as an education savings account, since money in the account can be used for education related expenses for K-12, college, graduate programs, and even student loans.

Here’s how a 529  plan works and how to navigate your options so you can maximize its benefits.

What are the benefits of a 529 plan?

529 plans are very powerful accounts to help families save for an education. They offer many benefits that primarily fall into two categories:

1. Tax benefits

• Reduced state income taxes: Some states offer an income tax deduction for contributions to a 529 plan. State rules vary and deductions are typically capped at a few thousand dollars. Each state has a different set of rules as to which 529 plan you must use in order to qualify for any tax savings.
• Tax-free growth: All money saved and invested in a 529 plan grows tax free, which means you don’t owe capital gains or income taxes while the money remains invested in the account.
• Tax-free money for education: Any earnings and growth in a 529 plan that are used to pay for qualified education expenses and even student loans (up to a limit) may be free from state and federal income taxes.

2. Affordability and flexibility

• Low account minimums: Some 529 plans allow you to start saving with as little as $25.
• Any level of education qualifies: Savings can be used to pay for qualified expenses at any level of education.
• All family members are eligible: If one family member doesn’t use the savings, they can be transferred to another family member (called a beneficiary change) for them to use with no tax penalties.
• Student loans qualify: Savings can be used to pay student loans subject to a $10,000 lifetime benefit for each person.
• In-state and out-of-state colleges qualify: With the right 529 plan, your savings can be used at any qualifying institution nationwide and aren’t limited to state schools.

529 plans are more flexible than many people think. Here’s how they work and what you need to know to make the most of them.

How does a 529 plan work?

A 529 plan is a lot like a Roth IRA, but for education. You contribute money that has already been taxed (also called after-tax contributions), your savings and investments in the account grow tax-free, and those savings can be withdrawn tax-free for qualified education expenses.

Although 529 plans stem from the federal tax code, they’re actually administered by each state. Each state gets to choose the investments they make available to account holders, the fees associated with the programs, the state tax benefits applied to residents, and how the two types of plans are managed.

Two types of 529 plans

Here are the two plans that states offer to help families pay for the costs of an education:

1. A prepaid tuition plan (only offered in a handful of states) locks in in-state tuition costs at today’s rates. You are essentially buying inflation protection against rising tuition costs. Families that make the required deposits, generally based on the age of the child, are usually guaranteed that their contributions will cover a predetermined number of semesters or years of tuition and fees at that state’s colleges and universities. Most prepaid tuition plans do not cover room and board and other costs. If your child decides to go to school outside of your state, the payout from the plan may be dramatically reduced. You may only receive your contributions back and will likely not receive the inflation-adjusted growth that’s guaranteed for in-state schools.
2. An education savings plan is an investment account that gives you more flexibility and a potential to earn higher investment returns than prepaid tuition plans, but it also comes with more risk. You choose your investments and achieve the returns, and possible losses, that may result from those investments over time. Education savings plans also allow you to contribute more to the account, which may allow you to cover a broader array of school related expenses. In addition, unlike prepaid tuition plans, you can use your savings at in-state and out-of-state schools, towards an education at all levels (K-12, undergraduate, graduate), and even to pay down student loans.

Both plans have advantages and disadvantages. Choosing the right plan for your child depends on your goals, desire to take on risk, and the flexibility you want when choosing a school.

Choosing the right 529 plan

All states sponsor (offer) at least one kind of 529 plan. No matter where you live, you do not have to enroll in the plan administered by your state. Families can enroll in another state’s plan and still receive tax-free earnings and growth and tax-free withdrawals for qualified expenses. Some states require you to contribute to your state 529 plan to receive the income tax deduction. So if your state offers an income tax deduction for contributions, and you contribute to an out-of-state plan, you will not get to reduce your taxable income on your state tax return.

While a state income tax deduction is enticing, there are other things to consider when choosing the right plan. First, you want to review the investment options available. Some states offer investments with low fees while others offer more expensive options with high fees that can eat into your returns over time. Second, you want to review the fees associated with the accounts. For the most part, administrative fees are pretty low, but it’s worth double checking to make sure you don’t leave any money on the table.

When choosing between a prepaid college trust and an education savings plan, it comes down to your overall goals for funding an education. Here are a few things to consider:

• Are you comfortable with investment risk or do you want the peace of mind that comes with keeping pace with, but not beating, the rising costs of college in your state?
• Do you want to help pay for any and all qualifying costs related to an education or do you simply want to cover tuition and fees?
• Do you want the flexibility to choose any school in any state and the freedom to use your savings how you choose or are you envisioning the recipient attending an in-state school?

Keep in mind that you can contribute to both types of 529 plans. Education savings accounts give you more freedom and flexibility when it comes to paying for college. Prepaid plans have limitations on how much you can save and how those funds can be used but ensure you aren’t paying an even higher cost for tuition and fees.

What qualified expenses does a 529 plan cover?

A 529 plan offers tax-free earnings growth and tax-free withdrawals when the funds are used to pay for qualified education expenses. Qualified simply means that the expense meets the IRS’ definition of an appropriate and necessary cost to get an education. The goal of having qualified and non-qualified expenses is to clearly define acceptable uses of 529 assets (qualifying expenses) and those that may be seen as abusing the spirit of the plans (non-qualifying expenses).

Qualified expenses include, but aren’t limited to: 

College and post-secondary expenses - Costs associated with enrolling in and attending a college or postsecondary school are eligible. These expenses include tuition and fees, room and board, books and supplies, and even some expenses related to computers and internet access. Remember, prepaid college plans only cover tuition and fees.

Some expenses, such as student health insurance, are not covered, unless the college charges them as part of a comprehensive tuition fee or the fee is identified as "required for enrollment or attendance" at the institution.

K-12 private tuition - Up to $10,000 per year in a 529 plan can be used for tuition expenses at public, private, and parochial schools from elementary school through high school with many of  the same tax benefits. This is a new provision that was established in the Tax Cut and Jobs Act of 2017 that became effective as of January 1, 2018.

Student loan repayment - The SECURE Act of 2019 created a provision to broaden the use and flexibility of 529 college savings plans. Account owners can now use up to $10,000 per beneficiary, over their lifetime, to pay down student loans without paying taxes and penalties on any earnings in the account. $10,000 may also be used to pay off student loans of the beneficiary’s siblings as well.

While 529 plans offer many benefits, some parents still worry about what happens to their savings if their child or beneficiary doesn’t need the money.

What if the money never gets used?

If your child doesn’t go to college or a qualified technical school, what happens to the money in their 529 plan? Or what if they get scholarships and less or no money from their 529 account?

Here are a few scenarios and what you can do in each situation:

• One child doesn’t need the money - Money in a 529 plan can be transferred to someone else in your family without penalties or taxes. So if you have one child that goes to college and one child who doesn’t, you can move the investment into the name of the child that is going to school. You can even name yourself as the beneficiary and head back to school to advance your career.
• Your child gets a scholarship - If your child gets a scholarship and doesn’t need the money, you can take money out of the 529 plan, up to the amount of the scholarship, and use it for non-education expenses. You’ll pay taxes on the amount you take out, as you would with many non-529 investments, but you won’t have to pay the 10% penalty for non-qualifying expenses (see below). Again, you can always change the beneficiary and use it for someone else’s education.
• You don’t need the money for school - You can withdraw the money, although that’s not ideal, and use it for a non-education purpose. You’ll pay taxes on the proceeds, plus a 10% penalty. However, legally you can only use money from a 529 account for the child’s benefit, not your own. The penalty is waived if the beneficiary receives a tax-free scholarship, attends a U.S. Military Academy, dies, or becomes disabled.

Or, a more prudent option is to roll the unused funds into a Roth IRA. Thanks to changes in the Secure 2.0 Act, now you can get a jump start on your retirement if you meet the following conditions:

• • The Roth IRA needs to be in the name of the 529 plan's beneficiary.
  • The 529 plan must have been held for at least 15 years.
  • Any 529 plan contributions within the last five years (and earnings on those contributions) cannot be transferred to a Roth IRA.
  • The annual IRA contribution limit is the same as the amount that can be transferred from a 529 to a Roth IRA.
  • $35,000 is the maximum amount that can be moved from a 529 to a Roth IRA during an individual's lifetime.
• You don’t need the money today - Finally, there’s no time limit for using the money you save within an education savings account. A child can get an undergraduate degree and use the money left in their account years later for further qualified education expenses, such as for a graduate degree. It would even be possible to leave the money in the account for future generations. Prepaid tuition plans often come with time limits on when you can use the credits so they offer less flexibility with timing.

If a 529 plan sounds like a good solution for your education savings needs, here’s what you need to know about how much you can save in any given year.

What to know about 529 plan contributions and limits

There are rules regarding 529 plan contributions that can be confusing to navigate. Here’s what you need to know about contributions, gift taxes, and annual limits.

• Annual savings limits - Technically, there is no limit on how much you can contribute to an education savings plan. However, any contributions are considered completed gifts for federal tax purposes so you will have to report any amounts over the annual allowable gift amount each year. For 2022, that limit is $16,000 per individual. Most people contribute somewhere between $0 and the annual gift limit in any given year to avoid the hassle of a reportable gift. Prepaid tuition plans may come with an annual contribution limit since they often only cover tuition and fees and this varies by state.
• Supercharging your savings - Should you want to supercharge your education savings, you can combine five years worth of contributions into one year. So for 2022, you could contribute $80,000 ($16,000 x 5). You still have to report this contribution on your tax returns (using Form 709), but it won’t run afoul of federal gift tax issues that can affect your estate planning. With this election, you simply have to show the IRS that you want to use your allowable gifts for the next five years and that you aren’t trying to make a taxable gift by exceeding the annual gift limit.
• Both parents and grandparents can establish accounts - If a parent made a $16,000 contribution to a 529 plan in a given year, a grandparent could still open their own account, for the benefit of the grandchild, and make a $16,000 contribution as well. Contribution limits based on the annual gift tax exclusion are per account owner per beneficiary. However, if grandparents use 529 plan savings to help pay for college, it can reduce the amount of financial aid your child may receive. This will change for the 2024-2025 school year, when 529 funds will no longer be required reporting on the FAFSA and will not affect financial aid eligibility. 

There is a lot to consider when it comes to saving for your child’s education. It’s important to determine how much you want to contribute to their education, how best to save to provide that support, and how to incorporate those savings into your broader financial plan.

Why proper planning is essential

Providing children with a quality education at all levels from kindergarten to college and even potentially through graduate school may be one of the greatest gifts a parent can give.  Soaring education costs often means taking out student loans, which can follow the borrower for a long time or result in sacrificing their very own retirement savings.

The good news is that with proactive planning, you can develop a savings strategy to make the education you envision a reality and keep your personal finances on track so you can enjoy life today all while preparing for a financially secure retirement tomorrow.