If you think there is no way you can afford to save for your children’s education, you’re not alone. As of 2017, only 20% of the parents in the U.S. were saving for college.
But consider this: Statistics show that students who have a college savings of only $1 to $499 are three times more likely to attend college and four times more likely to graduate from college than students with no savings at all!
By starting a savings account, your children know their education is a priority for you. ANY savings at all and your child is four times more likely to graduate college.
Statistics also show that 66% of millennial parents aren’t familiar with a 529 Plan for college savings, and only 4% of U.S. households are invested in a 529 Plan.
So, What is a 529 Plan?
A 529 Plan is simply an educational savings plan that is exempt from federal tax. This plan also has tax benefits at the state level, if your state has an income tax.
These 529 Plans began over twenty years ago to help taxpayers prepare for education expenses. Let’s look at:
- How a 529 Plan works
- The two types of 529 Plans – college savings and prepaid tuition
- Tax benefits of an education savings account
- The maximum contribution and deduction restrictions
- How the money in a 529 Plan can be used – you will be surprised just how versatile a 529 Plan can be when it comes to educational expenses.
How Does a 529 Plan Work?
A 529 account is an investment fund. There are generally two different types of investment options:
- An age-based option
- A static option
With an age-based option, your investment starts out in higher-risk stocks, which also tend to yield much higher growth. As your child ages, the fund gradually shifts investments to more conservative mutual funds and bonds.
With a static option, your investment begins and remains in a lower-risk fund or group of funds. This plan is more secure but yields lower returns.
You often can choose the plan that feels right for your goals. Stocks can be riskier, but there is more money to be made. Bonds are generally safer but make less money. Some plans offer insurance-backed guarantees or principal-protected funds, meaning the money you invest can be recouped.
A 529 Plan will be handled by the program manager, which is usually a fund company or financial institution. Most managers invest in U.S. stocks and bonds and diversify through emerging markets, commodities, and international investments. The money is invested in your name, but in custodial accounts (each account is for a specific beneficiary).
Although handled by the program manager, you have the final say in how your money is invested. You can also work directly with an advisor who will explain all the options to you.
What Are the Two Types of 529 Plans?
The two types of 529 Plans are College Savings and Prepaid Tuition. College savings are investment plans that invest your after-tax contributions in mutual funds. Prepaid Tuition plans are accounts that lock in the current cost of tuition.
- Prepaid Tuition Plans may be offered directly through the college or university and allow you to do just what they say: pre-pay the cost of tuition. Since tuition costs continue to skyrocket, prepaid tuition can potentially save you a lot of money.
Prepaid Tuition plans, however, are diminishing in accessibility. Many have stopped accepting new investors, others have even closed accounts completely. Prepaid Tuition accounts have other drawbacks as well. For instance, your investment may only apply to in-state schools. Also, room and board and many other costs are not included.
- College Savings Plans work like other typical investment accounts. Instead of a bank savings account or a savings bond, which will earn you a meager 2 to 4% on average, you are investing your money in stocks and mutual funds. Think of it as a Roth IRA, but for education instead of retirement.
While Prepaid Tuition plans have time limits for withdrawals, College Savings plans do not have time limits.
Bear in mind that, like your cell phone bill or mortgage, your investment will be subject to fees. Fees generally include:
- An account maintenance fee, which pays your plan manager for administrative costs.
- An advisor fee, if you choose to work with an advisor to help manage your 529 plan.
- A total asset fee, which is another management fee, based on the success of your portfolio.
These fees are pretty standard and can range widely, depending on the amount you contribute, your state’s regulations, how diverse your investments are, and how actively managed your funds are.
Some states waive certain fees. Be sure to ask your plan managers about any waivers that may apply. Also, your state tax deduction, where applicable, may counter some of your fees.
What are the Tax Benefits to a 529 Plan?
First, contributions to your 529 Plan or Plans are not deductible from your federal income taxes.
Still, more than half the U.S. states offer state income tax incentives or tax credits for 529 contributions. To get these deductions, you may be required to invest in your legal home state’s 529 plan.
Second – and more encouraging – funds that grow from a 529 plan are free from federal tax, and will not be taxed even when the money is withdrawn for qualifying educational expenses (we will cover these specifics later.)
How Much Can I Contribute to a 529 Plan?
For tax purposes, the IRS doesn’t specify a yearly contribution limit for 529 plans, since they are considered gifts. And while most of us don’t have to worry about hitting a maximum amount, there are still some rules to keep in mind.
For 2019, to qualify for the yearly tax exemption, contributions may total up to $15,000 per plan, per individual contributing to the plan. So, while only one person can own the account, and each account can only have one beneficiary, multiple people can contribute the maximum to an account and still get the exemption.
As far as a minimum is concerned, each plan has a different initial start-up amount (often as little as $25), but after the 529 Plan is in place, any further contributions are optional. You can start it and forget it, set up monthly withdrawals from your bank account, or make occasional lump sum contributions after holidays or tax returns.
The point is, you decide when and how much.
You can withdraw the money in a 529 Plan for any reason. However, if it isn’t used for qualifying educational expenses, it is subject to taxes and penalties. The IRS does allow tax-free withdrawals of up to $10,000 per year for qualifying educational expenses. Either way, you will need to report withdrawals on your annual tax returns.
How Can a 529 Plan be Used?
A 529 Plan can be used for accredited colleges and universities, and other eligible post-secondary educational institutions like trade schools and graduate schools. Qualifying educational expenses include:
- Lab fees and equipment
- Books and supplies
- Computers and internet fees
- Room & board or rent
For on-campus residents, room & board expenses are included, but cannot exceed what the college charges. For off-campus students, rent is considered a qualifying expense if the student is enrolled at least half-time, but is limited to the cost figures provided by the college. Financial aid offices will provide you with this information.
- K-12 tuition.
As of 2018, 529 plans can also be used for private elementary and high school. The difference is, for K-12, parents can withdraw up to $10,000 per student per year for tuition alone.
Non-qualifying expenses include things like health insurance, transportation costs, and – surprisingly – student loan payments. Withdrawals for these purposes will result in a 10% penalty and will also be subject to income taxes.
What Happens to the 529 Plan if my Child Doesn’t Need It?
What happens if the beneficiary of a 529 Plan chooses not to attend school, or doesn’t need the plan due to being awarded a full scholarship or being selected to attend a U.S. Military Academy?
If these situations occur, you have multiple options for your 529 Plan without incurring taxes or penalties:
- The account remains intact to be used by the named beneficiary at a later date.
- The funds remain in the plan for graduate school.
- The beneficiary can be changed to another family member
- You can make yourself the beneficiary and go back to school
- The money can be rolled into a 529 ABLE account – an account for people living with disabilities.
What States Offer 529 Plans?
As of 2018, all 50 U.S. states and the District of Columbia offer 529 College Savings Plan, and over half of those have tax incentives. Eleven states continue to offer 529 Prepaid Tuition Plans. U.S. News has a breakdown of each state’s regulations and policies that are worth checking out. Also, NerdWallet lists a state-by-state breakdown to include the names of each 529 Plan, what the tax benefits are, and what the minimum contribution requirement is.
The 529 Plan was created by Congress and named after section 529 of the Internal Revenue Code. Its legal name is the “Qualified Tuition Program,” and the IRS has a thorough Q&A page that covers any further questions and concerns you have.
Remember that saving always costs less than borrowing. A little now can go a long way later, both financially and motivationally. Just knowing you have invested in their future can make all the difference for your children. And with multiple 529 Plan options, you are sure to find one that meets your budget, your risk-comfort, and your financial goals.