How 529 Savings Plans Work
Since their debut in 1996, 529 savings plans have been one of the best vehicles available for covering college costs. Congress expanded these plans to cover K–12 education in 2017 and to pay up to $10,000 in student loan debt in 2019.
A major reason for the popularity of 529 savings plans is their tax advantages. The money you contribute to your account grows on a tax-deferred basis, and withdrawals are tax-free as long as they are used for qualified education expenses. That includes tuition, room and board, and fees. Many states also provide a tax deduction or credit for your contributions, especially if you live in that state and invest in one of its 529 plans. There are no federal deductions or credits for contributions.
An appealing feature of 529 savings plans is their relatively high contribution limits. There is no limit on how much you can contribute each year, although if you contribute more than $15,000 you can trigger federal gift taxes.
As useful as they can be, 529 savings plans are not your only option for building a fund for your child's education.
- 529 savings plans are among the best vehicles to cover the costs of college.
- The prepaid tuition plan is a type of 529 that can help cut future tuition costs.
- Coverdell Education Savings Accounts cover both college and pre-college costs but don't qualify for tax deductions or credits.
- Custodial UGMA and UTMA accounts can be used for purposes other than education.
- Roth IRAs have tax advantages similar to 529 plans and they don't count as assets for financial aid purposes.
Prepaid Tuition Plans
A prepaid tuition plan is technically another type of 529 plan. But it works differently from the more common and familiar 529 savings plan. The prepaid plan allows you to pay for future tuition at current rates, which could mean significant cost savings down the road. Although some states cap the total allowable balance in your account, those limits are relatively generous and range between $235,000 to more than $500,000.
The primary drawback of prepaid tuition plans is that they generally apply only to certain community colleges, colleges, and universities within a particular state. Unlike 529 savings plans, which can cover a wide range of expenses, including room and board, these plans are generally limited to tuition only.
What's more, few states currently offer prepaid tuition plans, while all 50 states and the District of Columbia have at least one 529 savings plan, and sometimes several. But if your state offers a prepaid tuition plan and you're reasonably certain that your child will be attending college there, this is an option worth considering.
Coverdell Education Savings Accounts
Before 529 savings plans were modified in 2017, Coverdell Education Savings Accounts (ESA) had a major advantage over them: They could be used to cover both college and pre-college costs.
For college savers, the potential advantage of a Coverdell ESA is that it can provide a wider array of investment options, such as individual stocks, than most 529 savings plans, which are typically limited to a menu of mutual funds.
Coverdell plans also have some significant drawbacks compared with 529 plans. The money you contribute won't get you any tax deduction or credit. Your contributions are limited to $2,000 a year. Another factor to consider is that your modified adjusted gross income (MAGI) can't exceed $110,000 for single filers and $220,000 for married couples filing jointly, as of the 2021 tax year.
It is permissible to front-load a 529 plan and not incur gift taxes by contributing five years of payments at once.
Custodial accounts established under the Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) do not provide the tax benefits of a 529 plan, but they do allow account holders a great deal of discretion in where the money is invested and how it is eventually used.
While balances in these accounts are to be used for the benefit of the child, they are not specifically earmarked for college. That may make them especially useful for parents who are unsure if their child will actually go to college. Like the Coverdell, investment options for the UGMA/UTMA are virtually unlimited.
UGMA/UTMA accounts don't have the tax advantages of 529 plans. This means that contributions don't earn any tax deduction or credit, and the account's earnings are taxable.
They can also have a negative impact on financial aid eligibility. Because they are considered assets belonging to the child, up to 20% of their balance is counted in computing the Expected Family Contribution on the Free Application for Federal Student Aid (FAFSA). By contrast, 529 accounts are considered parental assets, and only up to 5.64% of their balance is counted.
Although primarily intended as a retirement savings vehicle, Roth IRAs can be used for college planning. You won't get any upfront tax deduction but your account will grow tax-deferred and your withdrawals will be tax-free no matter for any reason, as long as you're age 59½ or older and have had a Roth IRA for at least five years. You'll have to pay taxes and generally a 10% penalty but you can withdraw your Roth IRA contributions (but not the earnings) at any time and for any reason, tax-free.
As an added Roth benefit, the money you hold in retirement plans (unlike a 529 plan) isn't counted as an asset when you apply for financial aid through the FAFSA.
There are a couple of downsides to using a Roth IRA instead of a 529 savings plan. One is that your contributions are limited to just $6,000 a year or $7,000 if you're 50 or older. Those are the limits for the 2021 and 2022 tax years. Still, if you have enough money to invest, there's no reason you couldn't fund both a 529 plan and a Roth IRA.
A further, and perhaps more important, downside of using a Roth IRA to pay for college is that you'll have less money for retirement when the day rolls around. And your child will have many more years to repay an education loan than you have to recoup your lost retirement savings.
What Makes the 529 Plan so Popular?
It's all about the tax advantages. Money grows tax-deferred, and withdrawals are tax-free as long as they are used for qualified education expenses. That includes tuition, room and board, and fees. Many states also provide a tax deduction or credit for your contributions, especially if you live in that state and invest in one of its 529 plans. There are no federal deductions or credits for contributions.
Why Would Someone Not Choose a 529?
A few reasons exist. You have to use the money for the intended purposes or pay a penalty to get it back. You need to check plans carefully for good performance and fees. Plans are limited to one beneficiary at a time; families with multiple children may need more than one.
Is Life Insurance a Good Option to Pay for College?
Life insurance is an option for some people. A big bonus is that you can take out a loan against your cash balance for college. The insurer will reduce your death benefit if you don’t pay back the loan, but that’s not necessarily a drawback if you intended the policy primarily as a college savings plan all along. Drawbacks also exist, so do the research.
While 529 plans are helping many families save and put their children through college, they aren't for everyone. Limits, fees and a few other rules may force families to look elsewhere. Those other ways to save include Coverdell Education Savings Accounts, custodial accounts established under the Uniform Gift to Minors Act or Uniform Transfers to Minors Act and Roth IRAs. Prepaid tuition options are available, although that's a kind of 529. Do the research and start saving.