An Expert Guide to College 529 Plans
Named after Section 529 of the Internal Revenue Code, 529 plans offer families a college savings strategy with significant tax benefits. Here’s how these plans work and how to navigate your options.
Two Types of Plans
Although 529 plans stem from the federal tax code, they’re actually administered by each state. Investment options, potential returns, tax advantages, fees, and rules vary by state.
First, you do not have to enroll in the plan administered by your state. Families can enroll in another state’s plan and receive many of the same tax advantages. Those advantages include earnings and capital gains that are free from federal taxes when proceeds are used for qualified educational expenses (more on that in a minute).
Second, most states have two types of plans:
- A prepaid tuition plan locks in in-state rates. Families that make the required deposits, generally based on the age of the child, are usually guaranteed that their contributions will cover four years of qualified education expenses at that state’s colleges/universities. Often, states offer the option of contributing less and partially covering the cost of an in-state school.
- A college savings plan that lets you choose from a list of investments. Proceeds are not guaranteed.
Note that friends and family members, not just parents, can contribute to a child’s 529 plan, subject to some dollar limits.
What Are Qualified Education Expenses?
A 529 plan offers tax-free earnings growth and tax-free withdrawals when the funds are used to pay for qualified education expenses, including, but not limited to:
- Tuition
- Fees
- Books
- Supplies
- Equipment
- Computers
Generally, proceeds can also be used to cover room and board, subject to some restrictions. Expenses for off-campus housing, for example, are generally limited to the cost of a dorm room and prepaid dining plan. If your student chooses off-campus housing that costs considerably more than the dorm, your 529 plan might only be eligible to cover some of the expenses.
Some expenses, such as transportation costs and health insurance, are not covered, 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 institution. Club/organization dues and other voluntary expenses would also be excluded.
Note that up to $10,000 in a 529 plan can be used for private school (K-12) per year, with many of the same tax benefits. This is a new provision that was established in the Tax Cut and Jobs Act of 2017.
Which Plan to Choose
If you’re sure the student will attend an in-state college or university, a prepaid tuition plan offers peace of mind. By making the required monthly or annual payments, all qualified educational expenses at any in-state higher education facility will probably be covered. (Some states guarantee the plan will cover all qualified expenses; some do not.) The state will invest your contributions. If the state’s returns exceed the costs of college, you will not receive the excess amount.
If the student chooses an out-of-state school, your 529 account will pay you a set amount based on your contributions. If the out-of-state school costs more, you or the student will have to make up the difference.
With a college savings plan, you choose how much to contribute and when. You also can choose your investment, though the selection is usually quite limited (which we don’t think is a bad thing in most cases).
You’re Not Limited to Your Own State
Families can invest in the college savings plan of any state, not just their own. The investment offerings and fees vary widely among states, which means other states may have plans with lower fees and better potential returns.
Two things to know:
First, although many states have plans administered by well-known companies, such as Vanguard and T. Rowe Price, it’s usually better to invest through a state than directly through the fund manager.
Second, many states offer state tax breaks to their own state’s residents. If yours does, and you plan to invest in an out-of-state plan, make sure you understand the tax consequences.
The Drawbacks of each type of 529 Plan
The drawbacks of prepaid tuition plans are fairly obvious:
- You have no idea if your young child will attend an in-state school in the future.
- Investment returns may be lower than you could achieve in a college savings plan
- If the plan’s returns exceed the cost of qualified tuition expenses, you won’t receive any of that “extra” money
College savings plans also have some downsides:
- Investments are subject to the same risks as non-education risks, including market volatility and potential losses
- In many cases, there are significant penalties if money from 529 plans are used for non-education expenses
- Investment options are often limited
What If We Don’t Need the Money Later?
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 need little or no money from their 529 account?
You have several options.
First, the money in a 529 is portable. 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 also transfer the investment to another family member.
Second, if your child gets a scholarship and doesn’t need the money, you can take out the amount of the scholarship annually and use it for non-education purposes. You’ll pay taxes on the proceeds, as you would with many non-529 investments, but there are no additional penalties.
Third, you can withdraw the money and use it for a non-education purpose. You’ll pay taxes on the proceeds, plus a 10% tax 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
- The beneficiary attends a U.S. Military Academy
- The beneficiary dies or becomes disabled
Finally, there’s no time limit for using the money. A child can get an undergraduate degree and use the money left in their account years later for further qualified education expenses later, such as for a graduate degree.
Not sure where to start, or if a 529 plan makes sense as part of your financial life? Want to keep up to date on the latest rules and regulations regarding 529 plans? Talk to a CFP® Professional who can act as a guide over the years to help you make the best decisions for your family.
Interested in learning more about 529 plans and the importance of finding the right one that fits your financial goals? Check out our lunch & learn here.