A 529 plan is a tax-advantaged savings plan that can be used to cover education expenses. Over the years, the scope of the 529 plan has expanded to include student loan repayment, apprenticeship programs, and the option to convert unused funds to a Roth IRA.
A 529 savings plan allows contributions to grow tax-deferred. Withdrawals are tax-free when used for qualified education expenses such as tuition, fees, room and board, and books at eligible institutions. Originally created for college expenses, 529 plans can now also be used for K-12 tuition and apprenticeship programs.
So, what exactly is a 529 plan? Here’s a comprehensive guide on 529 plans and how they can help you achieve your college savings goals for your children in the future.
529 plans: Understanding these tax-advantaged education savings accounts
A 529 plan enables a participant to establish a tax-advantaged account for a beneficiary to utilize for qualified education expenses. Participants contribute after-tax funds to the account, which can then grow tax-deferred and be withdrawn tax-free for relevant expenses.
Funding a 529 plan can potentially lower your taxes, as some states offer tax deductions on contributions. Contributions are made with after-tax money, so they do not qualify for federal tax deductions. Anyone can open and contribute to a 529 plan, including parents, grandparents, and other relatives. It’s even possible to use the plan to fund your own educational expenses. Depending on state laws, you may be able to claim a tax deduction for your contribution even if you’re not the account owner.
When making withdrawals from your 529 plan, it’s essential to use the funds for education expenses within the same calendar year to avoid penalties. Different state plans offer various benefits, so it’s advisable to research and select the plan that best suits your needs based on factors like cost, investment returns, and benefits.
Exploring the different types of 529 plans
There are two primary types of 529 plans: prepaid tuition plans and education savings plans. Each type serves distinct purposes and offers different investment options.
- Prepaid tuition plan: This plan allows you to purchase college tuition credits at today’s prices for future use. These credits can only be used at participating colleges and universities for the beneficiary and typically do not cover room and board or expenses for primary and secondary schools.
- Education savings plan: This type of plan is more comprehensive, allowing you to open an investment account to fund future education expenses. These plans cover tuition, fees, room and board, books, and other qualified costs at almost any U.S. college or university, as well as K-12 private education and other programs.
Education savings accounts can be invested in various assets, including stock funds, bond funds, and money market funds. However, investments in market-related funds are not insured by state or federal governments.
Tax and financial aid advantages
529 plans offer several tax and financial aid benefits to participants:
- Tax-deferred growth: Earnings in the account are not taxed as long as they remain in the account. In 2024, you can contribute up to $18,000 (or $36,000 for joint filers) per beneficiary without needing to file a gift tax return. Other contribution rules apply based on the state.
- Tax-free withdrawals: Using the funds for qualified education expenses allows you to enjoy tax-free gains on your earnings.
- Potential state tax deduction: Some states offer deductions on contributions, providing tax savings. However, you won’t receive a deduction for a state in which you do not pay taxes.
- Beneficiary flexibility: A 529 plan can benefit multiple children if they do not need to utilize the funds simultaneously. It’s essential to plan ahead to avoid violating any rules specific to the plan.
- Student loan repayment: Up to $10,000 can be used for student loan repayment, and an additional $10,000 can be allocated for siblings’ loans. However, depending on state laws, this may be considered a non-qualified distribution, potentially resulting in a tax liability. Each state’s 529 plan has its own set of rules, so understanding your state’s distribution guidelines is crucial.
- Lower financial aid impact for parent-owned accounts: Assets held in a child’s name can significantly reduce their eligibility for financial aid. Since a 529 plan is not owned by the child, parental ownership may have a lesser impact on financial aid. Recent changes in rules no longer require grandparents to report financial support for the 2024-2025 award year.
- Rollover to a Roth IRA: Unused funds in a 529 plan that has been open for at least 15 years can be rolled over into a Roth IRA for the beneficiary, with a lifetime limit of $35,000. However, the rollover amount cannot exceed the annual IRA limit, which was $7,000 in 2024.
Utilizing a 529 plan for multiple children
It is possible to use a single 529 plan for multiple children by changing the beneficiary after the first child’s graduation if there is a significant age gap between siblings. However, it’s essential to consider the remaining funds for subsequent children once the plan has been accessed by an earlier child.
Using a single plan may diminish its value for later children, especially if investment strategies are adjusted as the first child approaches college. Maintaining separate 529 plans for each child may be more beneficial, allowing for better record-keeping and potentially qualifying for additional state tax deductions if available.
Understanding qualified and non-qualified expenses
It’s crucial to note that 529 funds can only be withdrawn tax-free for qualified education expenses. Any expenses not meeting the IRS criteria for qualified expenses may result in penalties on withdrawals.
Expenses not explicitly identified by the IRS as qualified are typically not covered.
For higher education expenses, qualified expenses must be related to enrollment or attendance at an eligible post-secondary institution, with some costs required by the school and others incurred by students enrolled at least half-time.
Eligible expenses include:
- Tuition and fees charged by the institution.
- Required textbooks for enrolled classes.
- Room and board up to the amount specified by the school as part of the cost of attendance.
- Computers, software, and equipment primarily used for educational purposes.
- Apprenticeship costs for programs registered with the U.S. Department of Labor.
- Up to $10,000 in K-12 private education tuition expenses.
- Special needs services related to school attendance.
- Up to $10,000 in student loan repayment.
Transportation costs at college and extracurricular fees are examples of expenses not covered by a 529 plan without incurring penalties.
Initiating a 529 plan
If you’re considering opening a 529 plan, you can do so directly through a state’s plan or seek assistance from a broker or financial advisor to guide you through the process.
- Direct enrollment: Register on the plan’s website, assess investment options, and manage the plan independently. You will be responsible for overseeing the plan and addressing any issues that arise.
- Broker or advisor assistance: Work with a broker or financial advisor to identify the best state plan for your needs, select suitable funds, and receive additional advice on the program. However, this service may come with sales commissions or higher investment fees.
Fidelity Investments and Charles Schwab offer options to open 529 plans, which can be advantageous if you already have accounts with these companies.
Using a 529 plan at any college
529 savings plans can be utilized at any qualified college nationwide, with most states not restricting usage to the state that sponsors the plan. For example, you can contribute to an account from one state’s plan and use the funds at any eligible institution of higher learning.
Prepaid tuition plans, however, may have more limited usage, often restricted to specific colleges. While some state plans allow credits to be used at multiple public institutions within the state, using the credits outside the state may not be possible.
It’s important to verify the eligibility of your desired institution, as not all colleges may accept 529 plan funds.
Handling unused 529 plan funds
If a child decides not to pursue college or vocational school, the beneficiary can be changed to another family member who can utilize the funds. The plan can retain the funds indefinitely as long as a living beneficiary is listed.
After at least 15 years of account opening, unused funds can be rolled over into a Roth IRA for the beneficiary, with a maximum rollover amount of $35,000, subject to the annual IRA contribution limit. If the funds cannot be utilized, they must eventually be withdrawn. Failure to use the funds for qualified educational expenses or roll them over into a Roth IRA may result in taxes on earnings and a 10 percent penalty.
However, there are exceptions to avoid the 10 percent penalty (though taxes on earnings may still apply):
- Scholarship: Withdraw funds up to the scholarship amount if the beneficiary receives a tax-free scholarship.
- U.S. military academy attendance: This is treated as a scholarship.
- Beneficiary death: Withdrawals are permitted if the designated beneficiary passes away.
- Beneficiary disability: A physician’s certification of the beneficiary’s inability to engage in gainful employment is required.
- Employer education assistance: Withdraw funds equal to the employer’s assistance without penalty.