What is a 529 Plan?

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Definition:

A 529 plan is an educational savings plan that allows individuals to set aside money for elementary through college expenses while qualifying for certain tax benefits.

🤔 Understanding a 529 plan

With the price of college increasing drastically over the past several decades, many families are more concerned than ever about how they’ll afford the cost. One of the more popular ways that families can plan for college is by opening a 529 plan, which is a tax-advantaged college savings account. A 529 savings plan allows an account holder to contribute funds and will enable those funds to grow tax-free. As long as you use the money for qualified education expenses, you won’t have to pay taxes on the funds you withdraw at all (though you still pay federal taxes before you put them into the account). 529 plans are run at the state level, and almost every state has one. Like an individual retirement account, a 529 savings plan allows you to invest your contributions to help them grow.

Example

Let’s say Jim and Pam just had their first baby — And just like many American families, they’re already thinking about college. Jim and Pam decide to open a 529 savings plan for their child and make monthly contributions. Jim and Pam use the 529 savings plan to invest the contributions. When their child heads off to college, they will be able to withdraw the principal and the potential earnings to pay for tuition, and they won’t have to pay taxes on those withdrawals.

Takeaway

A 529 plan is like a retirement account, but for college…

Many retirement accounts allow you to contribute money in order to accumulate a source of future income. Then when it’s time to retire, you have a pool of money to withdraw (without having paid taxes on any potential investment gains during accumulation). A 529 savings plan allows you to contribute money, invest it, and then withdraw your principal and potential earnings tax-free when it’s time to pay for college. Both accounts help to save for a significant life event, and both come with their share of (but different) tax advantages.

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What are the rules for a 529 plan?

Because of the tax benefits they have, 529 savings plans are subject to some strict rules. First, there are rules as to what you can spend the money on. You can withdraw your earnings without paying taxes on them so long as they are going toward qualified higher-education expenses or elementary and secondary school tuition for the designated beneficiary. Qualified college expenses include tuition, room and board, books and supplies, computers, etc.

For a non-qualified withdrawal, you’ll pay taxes on the withdrawal of any earnings as well as a tax penalty. The one exception to this rule is if your child receives a scholarship, in which case you can withdraw cash up to the amount of the scholarship without paying the penalty.

Also, unlike some investment accounts that allow you to invest in a broad selection of investment options, 529 savings plans offer pooled investments — Most often mutual funds. These can be targeted to a specific segment of the market or age-based funds that change over time, but will vary with each state’s plan. SavingforCollege.com has a database with all state plans and their investment options.

There are also limits as to how many times you can change your investment selections. 529 savings plans try to discourage an active approach— They aren’t day-trading accounts. You typically can only change your investment option twice per year, or anytime you change the beneficiary.

What are the benefits of a 529 plan?

If you’re planning to send your child to college, putting your money into a 529 savings plan is definitely something to consider. First, the plans come with significant tax advantages. Your contributions have the potential to grow tax-free. Then, when it’s time to spend the money, you can withdraw it for qualified education expenses without paying taxes on it.

The assets in a 529 are generally associated with the parent(s), so it can have less of an impact on qualifying for financial aid If the account ownership is in your name or a spouse’s. This is a generalization as there are many determining factors so you need to do your research or consult with the appropriate professional.

These plans are also very flexible. The rule regarding qualified education expenses covers more than you might think. Sure, it covers tuition at a four-year school. But it also includes two-year schools, vocational programs, training programs, and other costs associated with education such as books and computers.

Are there any downsides?

529 savings plans can be a good way to prepare for the costs of college, but they have a few disadvantages as well. First, earlier providers tended to limit your investment options for a 529 savings plan. This problem is less common today, however.

The most significant downside to 529 savings plans is that they substantially limit what you can spend the money on. If your child’s education costs less than you think it will, or they don’t end up going to college at all, you’ll pay a penalty for spending the money on anything else.

How do you get a 529 plan?

The first step to establishing a 529 savings plan is to choose where to set it up. Almost every state has a 529 savings plan, but you don’t necessarily have to choose the plan in your home state.

Depending on where you live, it might make the most sense to choose your state’s plan. Many states offer a state income tax deduction if you contribute to a 529 savings plan in your state. But some states give you the tax break regardless of where your 529 savings plan is. But be aware of the actual benefit of the deduction compared to the plan’s expenses and investment options.

While you’re figuring out where to set up your plan, you’ll also have to decide if you want a savings plan or a prepaid plan.

After choosing your plan, you have to determine if you’re signing up for an individual account or a custodial account. In the case of an individual account, the parent is the account owner, while the child is the beneficiary.

For a custodial account, the child is both the account owner and the account beneficiary. As long as the child is a minor, they can’t manage the plan. In that case, a custodian (usually the parent) will manage the account until the child turns 18.

After you’ve determined where and how you’re going to set up your plan, it’s time to fill out the application. On the homepage for the plan you’ve chosen, there will typically be an “enroll now” button — This is how you’ll reach the form. Some states also allow you to fill out a form and mail it to the office where your state’s program is located.

To apply for the account, you’ll need the name of the account owner, the name of the beneficiary, and personal information about both individuals (this includes their addresses, telephone numbers, email addresses, and tax identification numbers).

Once you’ve set your plan up, it’s time to start contributing money. Every plan will allow you to transfer money from your bank account into the plan. You can either do this as an automatic transfer on a set schedule (weekly, monthly, quarterly, etc.) or manually whenever you want to contribute.

Putting money into the account is not enough — To make the most of what the 529 savings plan has to offer, you have to choose where to invest the money.

The more popular investment option is the age-based option. This type of fund is tied to the number of years until you need the money. In the early years, it automatically takes a more aggressive investing approach with higher-risk investments. The closer you get to the time when your child heads off to college, the less aggressive the investment strategy becomes.

Don’t worry about locking in your investments and changing your mind later — You can generally switch up your investments up to twice per year.

How do I choose a 529 plan?

There are two primary types of 529 plans. Much of the information in this article refers specifically to the savings plan, but there is also a prepaid plan option.

The savings plans allow you to invest your contributions and then use the money to pay for qualified education expenses. Investing in a 529 savings plan is kind of like investing in a 401(k) plan in that you can direct your investments and then use the money where you need it.

The other option, the prepaid plan, works a bit differently. Under this plan, you’re essentially paying for college ahead of time. The perk of doing it this way is that you’re locking in your child’s college tuition at the current price.

So if you’re paying for the 529 plan in 2020 and your child attends college in 2035, you paid 2020 college prices. This perk is good news if the cost of college follows its upward trend.

The downside to the prepaid plan is that this plan assumes your child will attend college in the state in which you have your 529 plan. If your child attends an out-of-state school somewhere else, the plan won’t cover their full tuition. It will only cover the average cost of your state’s in-state tuition.

There’s no hard and fast rule as to which plan is best — The two have different benefits. The significant advantage of the prepaid tuition plans is that you’re locking the price of college in at a lower price. On the other hand, you can’t choose your investments. Instead, the programs pool everyone’s money to make long-term investments. This type of plan is a defined-benefit plan. As long as you pay in the amount required, your state’s plan usually guarantees the money for your child’s tuition will be there when you need it. This type of plan is far less common and many states don’t offer them.

How do I fund a 529 plan?

One of the most critical steps to get the most out of your 529 plan is to fund it, meaning put money into it. You can add funds to your account in several different ways, including paper checks, electronic transfer, automatic transfers, and payroll contributions (if your employer offers it).

Every state limits contributions to a 529 plan in some way. These can be annual limits as well as total contribution limits (up to $500,000+)so you'll need to read the offering documents thoroughly. There are limits to how much you can deduct from your state taxes, and you also need to be mindful of gift-tax limits. Another upside to these accounts is that anyone can contribute money, so another family member — such as the child’s grandparents, aunts, uncles, etc. — can put money in on their behalf. Be aware that some states do have minimum contributions, where each contribution must be $15–$25, depending on the state.

It can be overwhelming to figure out how much to contribute. After all, you want to set aside enough to help your child pay for college, but not so much that it hurts your quality of life today.

Consider taking the current cost of college and dividing it by the number of years you have until your child turns 18. Sure, the cost of college will probably increase before then. But you’ll have the returns on your investments to help bridge that gap and you can always adjust your contributions as needed. The earlier you start, the less you’ll have to put away every month.

What happens to a 529 plan if I don’t use it?

529 savings plans are can be a compelling option because they allow the potential for tax-free growth, and you can withdraw the money tax-free as long as you spend it on qualified educational expenses.

But what happens if that’s not the case?

It could be that you over-saved for your child’s education, and now you have more money in the account than they need. If that’s the case, remember there are other things you can spend the money on besides just tuition. You can also spend the funds from a 529 account on things like housing, campus meal plans, books, computers, etc.

It could also be that you’ve saved for 18 years, and it turns out your child doesn’t plan to attend college at all.

First, most 529 savings plans will let you change the beneficiary. So if you’ve got another kid who will attend college someday, you can use the money for their education instead. You can also look into what other education or training your child might want.

Even if they aren’t attending a four-year college, plenty of vocational and career training programs also fall under the rules of the 529 savings plans, so it’s worth doing some research.

If all else fails, you can withdraw the cash from a 529 savings account to use for other purposes. The downside to this route is that you’ll first have to pay federal income taxes on the money, and then you’ll pay a 10% penalty.

Additional Disclosures:

Please note that tax benefits vary from state to state and should not be the only determinant in selecting a plan. Like any investment plan, it is possible to lose money in a 529 plan. Before investing in a 529 plan, you should fully consider the plan’s investment objectives, risks, charges, and expenses. This information can be found in the specific Plan Guide and Participation Agreement

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