What is a 529 Plan
A 529 plan provides tax advantages when saving and paying for higher education. There are two major types, prepaid tuition plans and savings plans. Prepaid tuition plans allow the plan holder to pay for the beneficiary's tuition and fees at designated institutions in advance. Savings plans are tax-advantaged investment vehicles, similar to IRAs.
Rules governing the plans are laid out in Section 529 of the Internal Revenue Code. They are legally referred to as "Qualified Tuition Programs" and sometimes called "Section 529 plans."
BREAKING DOWN 529 Plan
A 529 plan can be beneficial when considering the costs of higher education. According to The College Board, the average annual in-state tuition at a public four-year college or university tops $20,000 as of 2016, while the cost climbs to more than $45,000 at a four-year private university. Collectively, Americans owe more than $1.4 trillion in student loan debt.
Since its creation under the Small Business Job Protection Act of 1996, the 529 plan has become much more popular than other education-saving vehicles, such as education savings bonds and the Coverdell Education Savings Account. Total assets invested in 529 plans reached $275 billion at the end of 2016. In December 2017, congress passed a tax bill that allows 529 funds to also be used for private secondary schools as well.
A 529 plan allows a person to grow his or her savings on behalf of a beneficiary, who could be a child or grandchild, a spouse or even yourself. A 529 plan may be established by anyone, including non-relatives, for a designated beneficiary. There is no limit on the number of 529 plans an individual can set up, but contributions should not exceed the cost of education nor the limit as set by the state. So if a plan has more than one contributor, these contributors should inform each other of their contributions to ensure they don't exceed the limits.
The assets of a plan belong to the plan holder, not the beneficiary (although these can be the same person). The beneficiary has no claim on the assets, which can be withdrawn by the holder for any reason at any time, with penalties. A plan can be transferred to a member of the beneficiary's family, or excess funds can be rolled over into a family member's plan. Neither action triggers a penalty or taxes. Although the beneficiary does not control the plan's assets, they may affect his or her financial aid eligibility to a significant degree. The plan's assets are generally not counted as part of the plan holder's estate, so 529 plans confer estate tax benefits.
What is Covered Under a 529 Plan?
A 529 plan is meant to pay for qualified higher education expenses. Eligible expenses vary depending on the plan. Tuition costs and mandatory fees can always be covered by distributions. Eligible education institutions include colleges, universities, vocational schools or other post-secondary educational institutions eligible to participate in a student aid program administered by the Department of Education. This includes virtually all accredited public, nonprofit and proprietary (privately owned, profit-making) post-secondary institutions.
A 529 plan doesn’t just cover tuition, though. According to the IRS, it covers eligible expenses including "computer technology or equipment." These include desktop computers, laptops and any device controlled by the computer (such as a printer).
Internet service is also covered. However, cell phones and cell phone plans are not considered education expenses, nor is any technological device where the primary use is entertainment.
Outside of technology, meal plans, room and board and most other expenses related to schooling may be covered. However, transportation to and from school, expenses related to elective activities such as sports and clubs, and entertainment costs are not covered. Additionally, a 529 plan cannot be used to pay for student loans.
Types of 529 Plans
There are two main types of 529 plans: the college savings plan and the prepaid tuition plan.
Under a college savings plan, amounts are contributed up to the dollar limit of the plan. The assets in a college savings plan may be used to cover eligible expenses at any eligible educational institution.
Savings plans, which are only offered by states, are similar to IRAs in that they are tax-advantaged ways to invest money in the long term. Plan holders usually have the option to invest in a range of mutual funds. These funds may be targeted to the date the beneficiary is expected to start their education and attempt to reduce risk exposure as that date approaches. Since the investor bears the risks of the investments, the amount that is eventually available for eligible education expenses will be affected by the rate of return on the investments.
Some advisors recommend clients allocate 100% of the plan to stock-based funds until the beneficiary is 12 years old. While that sets you up for potential losses, unlike retirement, the student may qualify for grants and scholarships that lessen the burden on the 529 plan. If the plan suffers major losses, the other funding sources are there to pick up the slack. As the child nears college, more and more of the assets should be switched from stock-based funds to fixed-income vehicles to preserve capital.
If you figure that the cost of college will rise about 4% annually -- and you will earn about 6% annually on your contributions -- you have to contribute around $308 per month from your child's birth to the beginning of his or her college career at a four-year, in-state public university to cover 65% of the total cost. If you start later, you'd have to contribute more to reach that goal. (Use this calculator to figure out your contribution rate.)
Prepaid Tuition Plans
Prepaid tuition plans are offered by states and higher education institutions. In a way, they're analogous to futures contracts, as they allow the plan holder to prepay for one or more semesters at designated colleges or universities at current prices. This shields them from inflation in tuition costs, which has historically been much steeper than broader measures of inflation.
Under a prepaid tuition program, eligible expenses for a fixed period of time or a fixed number of credits are prepaid at an eligible educational institution. For example, an individual may make prepayments for two future semesters of college at today's cost. The prepayment guarantees the beneficiary two semesters, regardless of the cost in the future. This means that the program manager bears the risks of the investments. Contributions are limited to amounts necessary to pay the beneficiary's qualified education expenses.
Prepaid plans differ in their specifics, but often have limitations that do not apply to savings plans, such as age caps and residency requirements. They often have stricter limits on what expenses they can cover. Textbooks or room and board may not be eligible. On the other hand, some prepaid plans are guaranteed by states, while savings plans are subject to market risk.
Unlike the assets in the college savings plan, which can be used to pay for qualified expenses at any eligible educational institution, assets in a prepaid tuition program are usually used toward expenses at a predetermined educational institution, or an educational institution from a predetermined list. Should the beneficiary decide to attend an educational institution that is not included in the predetermined list, the current market value of the prepayments may not be sufficient to cover the cost of comparable tuition at the other educational institution. This means the beneficiary may need to cover the difference out of pocket.
There is one non-state prepaid plan, called the Private College 529 Plan (formerly the Independent 529 Plan), which allows holders to prepay tuition for a consortium of private schools. One problem with this plan, as with state plans, is that the choice of schools is limited. If the beneficiary does not get into and attend one of the selected schools, the funds may be rolled over into another plan, causing them to forfeit most of their gains. Alternatively, they can be transferred to a family member of the beneficiary or rolled over into that beneficiary's plans, which involves no penalty.
Tax Treatment of a 529 Plan
Earnings from a 529 plan are exempt from federal income taxes, providing withdrawals are used for qualified educational expenses. Distributions that are not used to pay for qualified educational expenses are subject to taxes and a 10% fee, with exceptions for circumstances such as death and disability.
Contributions to a 529 plan do not reduce your federal income tax burden by lowering your taxable income. However, more than 30 states provide tax deductions or credits for contributions in a 529 plan. Furthermore, 529 plans do offer certain federal tax advantages for contributions.
For example, while a gift over $14,000 would typically trigger gift taxes, there is a special exception for 529 plans. A contribution of up to $70,000 per person can be treated as if it were made over a five-calendar-year period, thus avoiding the tax if no further gifts are made to that child from the individual. If the gift is made early in the child's life, the money has a long time to grow before it's needed for college.
Choosing the Right Type of 529 Plan
The type of plan you choose -- whether a college savings plan or a prepaid tuition program -- is generally determined by what features and benefits you find attractive. For instance, do you want the beneficiary to be free to choose an educational institution that is to his or her liking, or are you happy to have the beneficiary attend an institution chosen from a predetermined list?
Furthermore, you should examine the range of plans or programs available for each type of 529 plan. For example, if you decide you prefer to establish a college savings plan, you should compare the features and benefits offered by your state of residence with those of the plans offered by other states. Some features that you'll want to compare include investment choices, fees and other expenses, restrictions and/or limitations of the plan (such as rules regarding the changing of beneficiaries or investment choices), and whether the plan allows for rollovers from other education savings programs.
Regardless of what 529 plan you choose, the important thing is that you make a choice and start early. For college savings plans, starting early increases the compound effect of the earnings on contributions. And for prepaid tuition programs, the cost of tuition is usually less if prepayments are made earlier.
Options for Withdrawing Money From a 529 Plan
As mentioned, withdrawals from a 529 plan are tax free if the money is used for qualified higher education expenses at an eligible institution. When it comes time to start distributing cash, there are three options available:
1. Sending a Check to the School
It may seem like having the funds sent directly to the school would be the easiest option, but it could be problematic if the withdrawal is supplementing a financial aid package. The school may opt to adjust the student’s financial aid award based on the amount of the 529 plan distribution. If the aid package is trimmed down too much, you may have to pull additional funds out of the plan or cover the gap out of your own pocket. (For more, see 529 Strategies That Maximize Student Aid Options.)
2. Sending a Check to Yourself
Having the check sent to yourself can sidestep that issue, but it puts you on the hook for making sure that your student’s expenses get paid. You also must report the distribution on your tax return, requiring you to file Form 1099-Q. This might trigger taxes and penalties on the distribution, even when the funds have been used for qualified education expenses.
3. Sending a Check to Your Beneficiary
This option poses the least amount of hassle, allowing you to bypass the issues of potentially diminishing a financial-aid package or causing a hiccup with your tax filing. Assuming the student is responsible about using the funds to pay for education expenses, the distribution would be considered tax free and wouldn't cause any snafus at tax time as long as your beneficiary files his or her own return.
And if such a distribution ended up being a taxable event, the earnings would be taxed at the beneficiary’s tax rate, not the plan holder's tax rate. Say, for example, that you have the plan send your student a $20,000 check to cover expenses for the upcoming school year, after which he or she suddenly receives an unexpected $5,000 scholarship. The amount of the scholarship that isn’t used for education expenses would be taxable income; however, the Internal Revenue Service wouldn't tack on the additional 10% penalty that usually applies when an excess distribution is made from a 529 plan.
While saving in a 529 plan offers parents and students numerous benefits, it’s important to have a strategy in place for withdrawing from your account once the time comes. Having the money paid directly to your beneficiary can minimize headaches, but you should check with your plan administrator to make sure it’s the best option.