Find out what a 529 plan is, the types available, how they work, and the pros and cons of choosing this savings option!
A 529 plan is a popular solution designed to help families save for higher education expenses while offering tax advantages. Today, we’ll dive deep into what a 529 plan is, the types available, how they work, and the pros and cons of choosing this savings option.
Recent updates have increased the flexibility of 529 college savings plans. For instance, the SECURE Act 2.0 now allows up to $35,000 of unused 529 funds to be rolled over into a Roth IRA for the beneficiary under specific conditions. This addition has made 529 plans an even more appealing option, as unused funds no longer risk penalties and taxes if the beneficiary does not pursue higher education.
What Is a 529 Plan?
It is a tax-advantaged investment plan designed specifically for educational savings. Named after Section 529 of the Internal Revenue Code, it allows individuals to grow their investments tax-free, provided the funds are used for qualified education expenses. These plans are popular for covering tuition, room and board, and other college-related costs, though recent updates also permit withdrawals for certain K-12 expenses, apprenticeship programs, and even student loan repayments in some cases.
Types of 529 Plans
College Savings Plans
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- These plans function similarly to a Roth IRA, allowing investments in mutual funds and other financial instruments;
- College savings plans have higher growth potential due to investment in various financial assets;
- Funds can be used for tuition, books, and room and board at eligible educational institutions;
- Market fluctuations impact investment value;
- Account owners can typically adjust investment options twice per year;
- Can be used for most accredited higher education institutions across the United States and some international schools.
Prepaid Tuition Plans
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- These plans allow contributors to prepay future college tuition at today’s rates for in-state public colleges;
- Prepaid tuition plans offer protection against rising tuition costs but generally lack the market-based growth potential;
- Limited to tuition and mandatory fees. Other costs like room and board are not covered;
- Typically only applicable to in-state public colleges, though some states may allow funds to transfer if the student attends out-of-state.
How Do 529 Plans Work?
They are accessible to any U.S. residents, regardless of income level. Once a 529 plan is opened, typically by a parent or guardian, contributions can be made at any time, up to the plan’s lifetime maximum limit (often set by the state, usually above $200,000). Here’s how it works:
- Contributions: are made with after-tax dollars, meaning they don’t reduce your taxable income at the federal level. However, some states offer deductions or credits for contributions to their state-sponsored 529 plans;
- Investments: contributions are invested in the account holder’s chosen options, and earnings grow tax-free. Investments are typically age-based, shifting from aggressive to conservative as the beneficiary nears college age;
- Withdrawals: when it’s time to use the funds for qualified education expenses, withdrawals are tax-free. If the funds are used for non-qualified expenses, a 10% penalty applies to the earnings, along with federal and state income taxes;
- Beneficiary Flexibility: the account owner can change the plan’s beneficiary at any time without tax consequences, as long as the new beneficiary is a family member. This flexibility is helpful if one child doesn’t need the funds or receives a scholarship, allowing the funds to support another family member’s education.
Pros and Cons of 529 Plans
Pros:
- Tax-Free Growth and Withdrawals: contributions grow tax-free, and withdrawals for qualified expenses are also tax-free;
- High Contribution Limits: 529 plans often allow contributions far exceeding the limits of other tax-advantaged accounts like IRAs;
- Flexibility in Beneficiary: account owners can transfer funds to another family member if the primary beneficiary doesn’t use them;
- Minimal Impact on Financial Aid: a 529 plan is considered a parental asset, meaning it has a limited impact on financial aid eligibility compared to other assets;
- Gift Tax Benefits: contributions up to $18,000 per year (or $36,000 for married couples) per beneficiary are allowed without triggering the gift tax. There’s also an option to front-load five years’ worth of contributions at once.
Cons:
- Penalties for Non-Qualified Withdrawals: funds used for non-qualified expenses incur a 10% penalty and taxes on earnings;
- Limited Investment Control: investment options are predetermined by the plan provider, giving the account owner limited flexibility;
- In-State Residency Requirements for Some Plans: prepaid tuition plans often require the beneficiary to attend an in-state college to use the funds effectively;
- Market Volatility: college savings plans are subject to market fluctuations, which could impact the total amount available at withdrawal.