How Does A 529 Savings Plan Work? Save For College The Smart Way

With college costs continuing to soar, you may wonder how in the world you’ll ever be able to pay for your kids’ education. Of course, the sooner you start saving, the better — especially with a 529 plan. These plans are specifically designed to make saving for future education costs as easy as possible.

They also carry some enticing benefits compared to other types of investment savings plans. See what 529 plans have to offer and if they’re the best fit for your financial planning needs.

Article Overview

• What Is A 529 Plan?
• Top 5 Benefits Of 529 Plans (Infographic)
• How To Open A Plan
• What Can I Use My 529 Plan For?
• 529 Plan vs Coverdell ESA, Roth IRA & UTMA
• Investing For Your Whole Family’s Future

What Is A 529 Plan?

A 529 plan is a tax-advantaged savings plan designed to encourage savings for future educational costs. These plans are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

Originally designed to cover post-secondary education costs, Section 529 now also covers K-12 education and apprenticeship programs. There are two types of 529 plans: education savings plans and prepaid tuition plans. Education savings plans are far more popular and offer the best flexibility for institutional options and covered expenses.

Education Savings Plans

These plans allow you to open an investment account to save for a beneficiary’s future qualified higher education expenses, including tuition, mandatory fees, room and board, and more. Typically, you can use the savings at any college or university (in some cases, even non-U.S. colleges and universities).

You can also use these plans to pay up to $10,000 per year per beneficiary for tuition at any public, private, or religious elementary or secondary school. All education savings plans are sponsored by state governments, but only a few have residency requirements for the saver and/or beneficiary.

Prepaid Tuition Plans

While not as popular as 529 savings plans, prepaid tuition plans could be a good option if you’re worried about continually rising tuition costs since they allow you to lock in current tuition rates for future education. The account holder can purchase units or credits at participating colleges and universities (mostly public and in-state) for future tuition and mandatory fees.

However, prepaid tuition plans can’t be used to pay for future room and board expenses, and they don’t allow you to prepay for elementary and secondary school tuition. Currently, fewer than 20 states sponsor prepaid tuition plans, and most have residency requirements for the saver and/or beneficiary. Some also have limited enrollment periods during the year.

Top 5 Benefits Of 529 Plans

1. Tax Breaks

With 529 plans, your savings grow tax-free, and your withdrawals are exempt from federal and state taxes as long as you use them for qualified education expenses. Although contributions aren’t deductible on your federal taxes, over 30 states currently offer a full or partial tax deduction or credit for 529 plan contributions. If your state offers tax benefits, it probably makes the most sense to go with your state’s plan. Otherwise, you can choose any other state’s plan.

2. Gift And Estate Tax Benefits

Contributions are also considered gifts for tax purposes, so deposits up to $15,000 per year per individual (in 2020) aren’t subject to the federal gift tax. You can also contribute up to $75,000 per individual per beneficiary in a single year without eating into your lifetime gift tax exclusion (essentially, you’re treating your contribution as if it was made over a five-year period).

3. Flexibility

Once you open a 529 account, you have some flexible options, including the ability to:

• Change your 529 plan investment options twice per calendar year
• Transfer the plan to another family member (children, siblings, nieces, nephews, first cousins, etc.)
• Transfer your funds to another 529 plan once per year

4. Easy To Maintain

If you’re not into investing details or just want a simple, hands-off way to save for education expenses, 529 plans are very maintenance-free. You can set up regular contributions via your bank account or through payroll deduction plans. And the account’s ongoing investment management is handled either by an outside investment company the state hires or by the state treasurer’s office.

5. You’re In Control Of The Funds

In most cases, the account’s named beneficiary has no legal rights to the funds in a 529 account. For example, when a child reaches legal age, he or she can’t take over the assets, so you know the funds will be used for educational purposes.

As a 529 account owner, you can also withdraw funds for any reason at any time in case you run into financial difficulty. But keep in mind, you will incur income tax and a 10% penalty on the earnings portion of the account.

5 Benefits Of 529 Savings Plans Infographic

How To Open A 529 Plan

All 50 states and the District of Columbia sponsor at least one type of 529 plan. With education savings plans, you can invest in almost any state 529 plan, not just your own state’s 529 plan.

To open a 529 plan account, you must:

• Be a U.S. resident with a legal mailing address
• Be age 18 or over
• Have a Social Security number or Tax ID

There are no income restrictions or a minimum amount required to open an account. While most people open an account for their children or grandchildren, you can also open an account for someone you’re not related to.

Are There Contribution Limits?

Currently, you have no limits on how much you can contribute to a 529 account each year, but many states cap how much you can contribute in total to an account. These limits recently ranged from $235,000 to nearly $540,000.

Why Would I Want To Invest In Another State’s 529 Plan?

If you don’t get in-state tax breaks, you may want to shop around for another state’s 529 plan. Why? Each state’s plan(s) differ in the types of investments they offer (i.e. the diversification of stocks, bonds, mutual funds, etc.), how the plans are managed, the overall performance of their plan’s offerings, returns, and more. So you may ultimately find a better investment option going with another state’s plan.

What Can I Use A 529 Savings Plan For?

Here’s a list of the 529 eligible expenses as well as those that don’t qualify, as defined by the IRS. As we stated above, if you use 529 funds for unqualified expenses, you’ll be subject to income tax and a 10% penalty. Note: the prepaid tuition plans only cover tuition and mandatory fees.

529 Qualified Expenses

• Tuition
• Mandatory fees
• Room and board (must be enrolled at least half-time)
• Computers, related equipment, and internet access
• Books and supplies
• Student loan payments

What Doesn’t Qualify?

• Transportation and travel costs to and from college
• Health insurance
• College application and testing fees
• Extracurricular activity fees

529 Savings Plans vs Other Education Savings Options

If you’re shopping around for the ideal education savings plan, you may have run into other types of plans. Here’s how the 529 plan compares to other popular options.

Coverdell ESA vs 529

The Coverdell Education Savings Account is the other main option in the U.S. designed specifically for education savings. Here are some key similarities and differences between 529 plans and Coverdell ESAs.

• With both plans, your savings grow tax-free.
• Unlike 529 savings plans, Coverdell ESAs aren’t state-sponsored, so you can open one with your broker. This gives you more flexibility in the stocks, bonds, and mutual funds you want to invest in.
• While 529 plans have no annual contribution limits, Coverdell contributions are limited to $2,000 per year. What’s more, this is a limit per-beneficiary, not per-account. So even if you and your child’s grandparents open separate accounts, the combined annual contributions can’t exceed $2,000 for that child.
• Coverdell ESA contributions don’t qualify for state tax deductions, while many 529 plans do.
• You must use Coverdell funds by the time a student is age 30, or you’ll incur hefty taxes, fees, and penalties with withdrawals.

529 vs Roth IRA

A Roth IRA is a retirement savings account, but unlike many other retirement accounts, you can take out money on the portion you’ve contributed at any time without penalties or taxes. However, if you withdraw the investment earnings for qualified college expenses before age 59½, you’ll likely owe income taxes. Here are some key similarities and differences between 529 plans and Roth IRAs.

• With both plans, your savings grow tax-free.
• While there are no income restrictions to open a 529 plan, your annual income must be under $139,000 (in 2020) to open a Roth IRA.
• You can only contribute up to $6,000 a year or $7,000 if you’re age 50 or older to a Roth IRA (for 2020), but there’s no annual cap on contributions to a 529 plan.
• There’s no state tax deduction for contributions to a Roth IRA, while some states give you deductions for 529 plan contributions.
• Roth IRA contributions don’t qualify for state tax deductions, while many 529 plans do.
• Money held in a Roth IRA isn’t counted for financial aid purposes, but withdrawals are counted as income — and that can affect your financial aid package. Qualified withdrawals from a 529 plan aren’t counted as income.

UTMA vs 529

A UTMA (Uniform Transfers to Minors Act) account is a custodial account that provides a way to transfer a variety of assets (money, real estate, patents, royalties, etc.) to a minor beneficiary. The gift-giver or an appointed custodian manages the minor’s account until the latter is of age (18 or 21 depending on the state). Here are some key similarities and differences between 529 plans and UTMAs.

• Tax benefits are generally more favorable with a 529 plan. With a UTMA account, earnings and gains are taxed to the minor. The first $1,100 of unearned income (dividends, capital gains, and interest on your contributions) is tax-exempt, but unearned income over $2,200 is taxed at rates for estates and trusts.
• UTMA accounts have no total maximum contribution limits, while most states cap the total in a 529 account.
• You’re not limited to qualified withdrawals with a UTMA account.
• UTMA accounts could make it harder for a student to qualify for need-based financial aid. While 529 plan assets are counted as the account owner’s assets on the FAFSA (Free Application for Federal Student Aid) form, UTMA account assets are counted as the beneficiary’s assets. It’s harder for a child to qualify when the assets are theirs.
• Ownership of a UTMA account transfers to the beneficiary when they turn either 18 or 21. With 529 plans, account holders can retain ownership no matter the age of the beneficiary.

Investing For Your Whole Family’s Future

Now that you’re thinking about investing in your child’s future education, you may want to make sure you cover all your bases to protect you and your family’s financial future. Our experts’ guide to investing can help you plan for your retirement, as well as decide how to invest your money more smartly.