There’s no denying that college is expensive. A student could easily spend $200,000 or more for four years of education.
While student loans are one option for covering education expenses, many parents want to help their children pay some or all of the cost of college.
A 529 plan is a great way to do this, offering significant tax benefits to savers who use them to cover educational expenses.
In This Article
- What is a 529 Plan?
- How Do 529 Plans Work?
- Advantages of a 529 Plan
- Drawbacks of a 529 plan
- What if I Have Extra Money in a 529?
What is a 529 Plan?
A 529 plan is a special type of savings or investing account designed to help people save for education costs. Think of it like an IRA or a 401(k), but for education.
When you open a 529 and contribute money to it, you receive tax benefits. The benefits vary from state to state, but the federal tax benefits are uniform regardless of where you live.
When you withdraw money from the plan, you do not have to pay taxes on the withdrawals as long as you use the money toward educational expenses.
The effect is that you can use a 529 to save for college and make each dollar go further by reducing the taxes you pay on the money.
How Do 529 Plans Work?
Understanding how 529 plans work is essential to making sure you get the most out of yours.
When you open a 529 Plan, you have to name the person who will benefit from the plan. For example, a parent opening the plan might name their child as the beneficiary.
When you take money out of it to pay for education, you have to use it for the beneficiary’s costs.
You can’t use one 529 to cover two people’s educational expenses. Using the money for someone other than the named beneficiary incurs a tax penalty.
The good news is that you can change the beneficiary of a 529 without much trouble. If you have extra money left in the account after the beneficiary graduates, you can change the account’s recipient.
This choice can also help in other situations, such as the beneficiary deciding not to attend college.
Tax Advantages and Contribution Limits
A 529 plan is similar to an IRA or a 401(k), but for educational expenses. When you put money in a retirement account, you get certain tax advantages. Similarly, when you put money in a 529, you get some tax benefits.
At the federal level, the money in a 529 grows tax-free. You pay income tax on the money that you contribute to the account.
When you withdraw funds, you don’t have to pay any taxes on the withdrawals, whether you withdraw principal or earnings.
As long as you use the money toward educational expenses, you don’t have to pay taxes on any of the funds you take out.
Depending on where you live, you might get some additional benefits. Each state has different rules surrounding 529s, and you might be able to reduce your state taxes by using one.
For example, Massachusetts residents can deduct the first $1,000 they deposit to a 529 from their income when filing their state tax return.
That means they’ll pay less tax when they contribute and won’t pay tax when making withdrawals.
Invest Contributions for Growth
You can open 529 plans with a variety of financial institutions.
CollegeBacker is an online 529 financial plan that is simple to use. They also offer calculators to see how much you need to save by when.
One popular strategy is to open a 529 with a brokerage account and invest the money. Let’s say you start saving early and have plenty of time before you expect to need to use the money in a 529, then investing makes sense.
Putting the money into the stock market can help it grow faster than a savings account or CD.
However, remember that there is always a risk with investing, so you’ll want to adjust the portfolio as the 529’s beneficiary nears college age.
Something unique about 529 plans is that individual states operate them. Each state will offer different investment options and various brokerages that you can work with.
For example, some states let out of state residents use their 529s, while others are more restrictive. Besides, you may not qualify for your state’s 529 tax benefits if you use an out of state 529 instead of your home state’s plan.
Because each state’s plan uses different investment options, the plan you choose can have a major impact on your investment performance.
It’s important to take the time to compare the different plans and their investment options.
Also, take the time to look at the fees that each investment charges because some funds may charge much higher fees than others.
In some cases, it may be worth losing out on the tax benefits your state offers to invest in a lower-cost fund.
Spend Money for Educational Expenses
It’s important to remember that the money you put in a 529 plan is earmarked for educational expenses.
There are restrictions on how you can use the money in the account beyond having to use it for the named beneficiary.
You can only use the money in a 529 for qualified educational expenses. However, this restriction does not only include college.
Parents can withdraw up to $10,000 per year from a 529 to pay for private K-12 schooling. But the money can only be used to cover tuition and cannot go toward fees or other related expenses.
Once the beneficiary enters college, the plans become slightly less restrictive. For college students, qualified educational expenses include:
- Supplies and equipment required for attendance
- Room and board (for students attending at least half time)
This includes only:
- The actual costs charged by the school for students living on-campus
- Budgeted figures listed in the school’s cost of attendance for student living off-campus
If you make a withdrawal from a 529 and don’t use the money for a qualified educational expense, you’ll have to pay taxes on the withdrawals, plus a penalty.
The penalty you pay on non-qualified 529 withdrawals is 10% of the amount withdrawn. You also have to pay income taxes on the earnings in the account.
You pay income taxes on the money you contribute, so you only have to pay taxes on earnings rather than principal when making a non-qualified withdrawal.
However, while you don’t have to worry about double taxation, the 10% penalty is still a significant hit, and you should avoid it whenever possible.
Advantages of a 529 Plan
There are many reasons to use a 529.
Save Toward Future Educational Costs
The main reason to use a 529 is to save for future educational costs. The obvious benefit is that 529s offer tax incentives for saving, which can help you save more money than you would otherwise be able to.
The other benefit is that having a separate account dedicated to saving for education makes it easier to avoid spending that money.
If you keep your savings in a single bank account, you might feel tempted to spend it on something other than education. To be sure, keeping the money separate helps reduce that temptation.
The fact that 529s don’t have to be used for college and can be used for other purposes, like private schooling or trade school, makes them useful even for people who won’t attend college.
And they make a great gift. Sites like CollegBacker offer the option to create a 529 as a gift. This is a great option for Grandparents or Aunties that want to give the gift of education.
Another benefit of using a 529 to save for education is that you can save money on your taxes.
No matter where you live, you get federal tax benefits for saving in a 529. If you use the money in the account for qualified expenses, you pay no taxes on your savings growth.
This benefit can save you a significant amount in taxes, especially if you’re in a high-income bracket.
People in certain states can get additional savings. For instance, some states let you deduct a portion of your 529 contributions from your income when filing your taxes.
With this deduction, it means every dollar you save costs you less than a dollar out of pocket. This only increases the benefits of using a 529.
Reduced Effect on Federal Student Aid
One of the primary ways that students get financial aid for college is by filling out the Free Application for Federal Student Aid (FAFSA).
One of the things included in the FAFSA’s calculation of how much a student and their family can expect to pay is the total value of the parents’ assets.
In general, the more assets that a family has, the more they are expected to contribute toward the cost of education and the less financial aid they’ll receive.
Money in a 529 owned by a parent with a child as the named beneficiary has a small impact on the FAFSA’s calculation of the family’s expected contribution.
Money taken from the account does not count as income for the student, further reducing its impact on student aid. This means that families generally are not punished with less help if they save money using a 529.
Drawbacks of a 529 plan
529s aren’t perfect, so it’s essential to understand their drawbacks before opening one.
Penalties for Non-Qualified Expenses
There is a precise list of qualified educational expenses that you can pay for using money in a 529.
If you use money from the account for any other purpose, you have to pay a 10% tax penalty on top of any taxes owed on the earnings in the account.
If you keep your savings outside of the 529, you won’t be restricted in spending it. Avoiding the 10% penalty in this way may leave you with more flexibility and spending power in the end.
Limited Investment Options
Each state administers a 529 plan and chooses the available investment options. You can’t simply go to any brokerage company, open a 529, and invest your money in any security of your choosing.
You have to choose from the options offered by the 529 plan you choose. If you’re an advanced investor who wants to use a specific strategy for investing the money in a 529, you might feel restricted by the limited options.
Other Goals May be More Important
Saving for college, especially if you’re trying to help your child pay for their education, is admirable. However, other goals might be more critical.
Students can get loans or work to pay for their education, but it’s much harder to borrow money to finance a retirement.
You might decide that other goals, like retirement saving or saving for a down payment on a home, are more important than saving for college. If you put money in a 529, you can’t repurpose it for other goals without paying the penalty, which makes the account restrictive.
If you’re not sure that you want to dedicate your savings toward paying for education, opening a simple savings account or CD at a bank that pays high-interest rates, like CIT Bank or BBVA, is a good place to start.
You can always move the money into a 529 if you decide to do so later.
What if I Have Extra Money in a 529?
You may find that you have too much money in your 529 for a few reasons. The plan’s beneficiary might get a full-ride scholarship and not need as much as expected, or they might decide not to go on to college.
Regardless of why it happens, you’re not out of luck if you have extra money in a 529 plan. You can always change the beneficiary of the plan, giving you the chance to help someone else cover the cost of education.
This choice can help if you have multiple children or have a close friend or family member who is attending college. If you want to think long-term, you can even hold the 529 and pass it to your grandchildren.
In the worst case, you can pull money out of the account. You’ll pay a 10% penalty on the withdrawals, but it will let you use the funds for other purposes.
There is no denying the cost of college these days is expensive. A 529 plan is a great way to save for college because it comes with a bevy of tax benefits and is relatively flexible.
Perhaps you want to help your child save for college, or even aspire to set aside some money for yourself for continuing education. If so, a 529 plan is one of the better options out there.