Planning for college expenses can be one of the biggest financial challenges for families but leveraging a Section 529 plan early and wisely can ease the burden. However, an overwhelming majority of Americans are not aware of 529 plans, let alone how they work.
A 529 plan is a savings plan designed to encourage families to save for future educational needs, legally known as “qualified tuition plans.” There are two types of 529 plans, prepaid tuition plans and education savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan, and participants can choose any state’s plan, regardless of where they live.
Prepaid Tuition Plans
Some colleges participate in prepaid tuition plans (state residency is sometimes required). Prepaid tuition plans let people purchase units or credits at participating colleges and universities for future tuition at current prices for the beneficiary. Typically, these plans cannot be used to pay for room and board.
Education Savings Plan
Education savings plans let a saver open an investment account to save for the beneficiary’s future qualified higher education expenses – tuition, mandatory fees, and room and board. Withdrawals from these accounts can generally be used at any participating college or university. Since its inception in 1996, these plans have been used for higher education costs (i.e., college); however, because of the 2017 changes to the tax code, they can also be used to pay up to $10,000 per year per beneficiary for tuition at any public, private, or religious elementary or secondary school (unlike prepaid tuition plans). There has been some confusion between the individual plans’, the states’, and the federal rules, so it’s best to consult a tax professional to ensure your distributions align with the new rules.
Tax Benefits
529 plans have grown in popularity (although not nearly enough) because of the tax breaks they allow, regardless of income. Generally speaking, as long as the funds are used to pay for educational expenses (expenses must be “qualified” as stated in the tax code), the account not only grows tax-deferred but the funds are also tax-free when withdrawn. Further, depending on which state you reside in, and which state plan you choose, there may be an upfront tax deduction for contributions into the 529 plan itself. However, if you take funds out for non-educational expenses, you will have federal income taxes to pay on the gains and a 10 percent penalty. There could also be state taxes due depending on the upfront deductibility of your contributions.
529 plans are also popular because of their incredible flexibility. For instance, if a child doesn’t attend college or doesn’t use all of the funds in the account, the funds can be transferred to another beneficiary within the family (or even the parent).
As mentioned above, there are many state plans available offering different investment options and associated fees. Be sure to evaluate your state’s plan first, then research the others to determine the right fit. While simple in concept, there are numerous restrictions, tax implications, and funding strategies that are too many to mention and require expert advice. Be sure to discuss your options and needs with your financial planner or tax consultant on these issues.