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What Is a 529 Plan?
A tax-advantaged savings plan that is designed to help pay for education is what a 529 plan is.
Originally it was only limited to post-secondary education costs and is now covering K-12 education in 2017 and apprenticeship programs in 2019.
The savings plans and prepaid tuition plans are the two main types of 529 plans.
When withdrawing the savings plans are tax-free if they’re used for qualified education expenses.
The account owner is allowed to pay in advance for tuition at designated colleges and universities with prepaid tuition plans, by locking in the cost at the current rate. 529 plans are also known as qualified tuition programs and Section 529 plans.
Understanding 529 Plans
Section 529 of the federal tax code is the source of the name of 529 plans, these plans are administered by the 50 states and the District of Columbia.
Anyone can open a 529 account, which has been established by parents or grandparents on behalf of a child or grandchild, who is the account’s beneficiary.
In few states, the person funding the account is eligible for a state tax deduction for his contributions.
Until it is withdrawn the money in the account grows on a tax-deferred basis.
Those withdrawals aren’t subject to either state or federal taxes till the time the money is used for qualified education expenses, as defined by the IRS.
For K-12 students, tax-free withdrawals are limited to $10,000 per year.
There are no limits on the amount that you can contribute to a 529 account each year, but there a cap put on how much you can contribute to it in total by many states.
Those limits recently cover anywhere between $235,000 to over $500,000.
Types of 529 Plans
college savings plans and prepaid tuition plans which are the two main types of 529 plans have some significant differences.
Savings Plans
The more common type is saving plans. Here the account holder contributes money to the plan, which is typically invested in a selection of mutual funds.
The funds can be chosen by account holders that they want to invest in, and depending on the fund’s performance the account growth or shrink will be determined over time.
As the years go by the target date funds are offered by many 529 plans which adjust their holdings, becoming more conservative as the beneficiary comes closer to college age.
The 529 savings plan withdrawals can be used for both college and K-12 expenses. The qualified expenses of a 529 savings plan include tuition, fees, room and board, and other related costs.
The SECURE Act, which is a 2019 federal law, expanded tax-free 529 withdrawals to include registered apprenticeship program expenses and for both account beneficiaries and their siblings a debt repayment of up to $10,000 in student loan.
Prepaid Tuition Plans
Only a limited number of states and some higher education institutions offer prepaid tuition plans.
Though their specifics vary, the general principle is that a student who may not be attending college for years to come is allowed to lock in his tuition fee at current rates.
These prepaid plans are unavailable for K-12 education.
Prepaid tuition plans grow in value over time with 529 savings plans, and the money that eventually comes out of the account to pay tuition does not attract tax.
The prepaid tuition plans do not cover room and board like savings plans.
There may be other restrictions with prepaid tuition plans, like some particular colleges they may be used for.
While the money in a savings plan can be used at just about any eligible institution.
The 529 Plan’s Tax Advantages
Only if the money is used for qualified educational expenses then the earnings in a 529 plan are exempt from federal and state income taxes.
Except for certain circumstances like death or disability any other withdrawals are subject to taxes plus a 10% penalty.
The 529 plan contribution is not tax-deductible for federal income tax purposes, However, tax deductions or credits of varying amounts for contributions to a 529 plan are provided by more than 30 states.
If you want a state tax deduction or credit then you’ll have to invest in your home state’s plan.
And if you’re willing to sacrifice a tax break, some states will allow you to invest in their plans as a nonresident.
Under Section 529 there are very specific transferability rules that are governed by the federal tax code with 529 plans.
Unless a beneficiary change is involved the owner is allowed to transfer to another 529 plan once per year.
To change beneficiaries the owner is not required to change plans. The plan may be transferred to another family member, defined as:
- Son, daughter, stepchild, foster child, adopted child, or heir.
- Brother, sister, stepbrother, or stepsister.
- Father or mother or ancestor of either.
- Stepfather or stepmother.
- brother or sister’s son or daughter.
- Brother or sister of father or mother.
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
- The spouse of any individual mentioned above.
- First cousin.
Just like other kinds of investing, where if you started earlier you get better returns, even with a 529 savings plan your money will have more time to grow and compound if started early.
You’ll most likely be able to lock in a lower tuition rate if you opt for a prepaid tuition plan because many schools raise their prices every year.
Because the beneficiary got a substantial scholarship or decides not to go to college at all and you have money leftover in a 529 plan, then you have several options.
One is you can change the beneficiary on the account to another relative. Another option is to let it be in the current beneficiary’s name just in case they change their mind about attending college or go on to graduate school later.
In a worst-case scenario, you can always cash in the account and pay the taxes along with a 10% penalty.
Conclusion
The tax-advantaged accounts that can be used to cover educational expenses from kindergarten through graduate school are 529 plans.
Savings plans and prepaid tuition plans are two basic types of 529 plans. The states run 529 plans, and their rules are different.
It is not necessary to only invest in your own state’s 529 plan, however doing so may get you a tax break, so check out that plan first.
