Most people don’t want their children to go through the same student loan debt spiral that they dealt with — or are still dealing with. But student loan debt is fast approaching $1.8 trillion, and tuition costs are going up. Tuition and fees increased by 1.6 percent across all four year in-state schools in the past year alone. Thankfully, 529 plans can help.
College is expensive, and now more than ever it’s tough for parents to understand how they will afford to help out their children.
Sabrina Hamilton chose a 529 plan to do just that. Though she and her husband have a one-income household and could afford to contribute only $50 a month, Hamilton opened the account for her then 3-year-old son. After 15 years, Hamilton and her husband had over $22,000 in the account.
“We were able to supplement our son’s financial aid and pay for expenses such as textbooks and living costs,” Hamilton says. “This reduced his overall financial responsibility and allowed him to rely only on a part-time job while in college.”
Hamilton stresses that even though they couldn’t contribute much at the beginning, the 529 plan was smart planning on their end. “Although we still can’t afford to foot a four-year bill, I’m thankful we have the account to offset the costs of higher education. The 529 savings plan has been an important financial vehicle to help support our children’s
goals after high school.”
Unlike Hamilton, Melvina Douse, 46, and her husband didn’t start a 529 plan for their son until he was in middle school. Douse feels that had they been made aware of it sooner, they would have been in a better position to set more aside and invest strategically with the longer timespan.
“My tax preparer recommended we start one for my son around the end of middle school,” says Douse. “My husband and I both had modest middle-class salaries and also had purchased a house.”
“Had we been coached sooner about his educational career, such as before he started middle school or when he just started elementary school, we would have been in a better position to set aside more each month and pick a better mixture of investments based on his age,” Douse says.
What Is a 529 Plan?
A 529 plan is a tax-advantaged savings plan that encourages savings for future education costs. Funds contributed to the account are invested and grow tax-free over time.
Legally defined as a “qualified tuition plan,” 529 plans are sponsored by a state, state agency, or educational institution.
This means the sponsor chooses a plan manager and decides the rules and limits for the plan.
If the funds in the account are used for qualified educational expenses, those withdrawals are not subject to federal income taxes, and in many cases, not subject to state taxation either.
These plans are commonly opened by parents or grandparents, who make regular deposits for later use when their children or grandchildren matriculate to college. The person who opens the 529 account is the account owner; the person who will use the funds for their education is the beneficiary.
There are basically two types of 529 plans: college savings plans and prepaid tuition plans. The plans are available to individuals in all 50 states and the District of Columbia.
The Difference Between the Two Types of Plans
A college savings plan, the more common of the two, provides more flexibility than a prepaid tuition plan. This plan allows the account holder to save for all of the beneficiary’s future qualified higher education expenses, such as tuition, fees, and room and board.
Withdrawals from this plan can generally be used at any educational institution, sometimes including those not based in the United States. And unlike prepaid tuition plans, college savings plans can even be used to pay for tuition at any public or private elementary or secondary school (up to $10,000 per year per beneficiary.)
A prepaid tuition plan allows the account holder to purchase units or credits from participating colleges and universities for future tuition at today’s current rates.
While state governments sponsor most of these plans, it’s important to bear in mind that many have residency requirements for the account holder and the beneficiary, and are not guaranteed by the federal government.
This means the account holder or beneficiary may have to reside in a certain state in order to take advantage of that state’s 529 plan.
Not all state governments guarantee (promise a minimum return on investment) the money paid into a prepaid tuition plan they sponsor, and if they do not, plan owners face the risk of losing some or all of their contributions.
On top of that, there are limitations as to how contributions can be spent. For example, if the beneficiary of the prepaid tuition plan elects not to attend a participating educational institution, the plan may pay only a small return on the original investment by the account holder.
Likewise, beneficiaries using prepaid tuition plans cannot use their funds to pay for other school-related costs like room and board.
How Do These Plans Gain Value?
College savings plans act like investment portfolios, whereby the account holder can choose from a variety of investing options like mutual funds or exchange-traded funds in order to grow their account funds.
State governments sponsor all college savings plans, and not many of them have residency requirements. State governments do not guarantee college savings plans.
Depending on the type of plan, your contributions may be subject to fees.
These fees can be for enrollment, application, and ongoing administration.
College savings plans are subject to more fees such as asset management fees and ongoing program management fees. There may be sales charges on some plans available through brokers — all plans may benefit from the oversight of a financial advisor.
The Financial Industry Regulatory Authority (FINRA) has a calculator to help account holders understand how account fees will impact their investment.
Some states offer grants and matches on 529 accounts, like Colorado’s College Invest Matching Grant program, which matches eligible account holder’s contributions of up to $500 a year.
States also may provide funds upon an account’s opening, such as Connecticut’s Higher Education Trust’s (CHET) program Baby Scholars. The beneficiary must be under 1 year old, and once the account is open, CHET deposits $100 into it, no matter what the account holder deposits. CHET also matches contributions up to $150 before the beneficiary turns 4.
These examples demonstrate how it may be helpful to check with the state government to see what benefits are offered when choosing a 529 plan.
How Does a 529 Plan Work and Who Can Contribute?
Anyone can open and maintain a 529 plan, whether the beneficiary is their child, another family member, or the account holder themselves. As mentioned previously, the person who opens and maintains the plan is the account holder, and the person who will use the funds for their education is the beneficiary.
This means the money in the plan belongs to the account holder initially, not the beneficiary. If there are state tax credits or deductions for the contribution, which will be covered later, the account holder benefits from them.
And if the beneficiary doesn’t use some or all of the funds in the account, those funds also remain the property of the account holder.
However, having one account holder does not limit who can contribute. Any third party can contribute, regardless of who owns the account. This means contributions can come from parents, grandparents, aunts, uncles, and even family friends; contributors do not need to be family members.
Another incentive of 529 plans is the lack of maximum annual account contributions — though it is important to note that the total amount cannot exceed the amount necessary to pay for higher-level education expenses of the intended beneficiary.
On top of that, some states have their own total contribution limits, though this is usually quite high. For example, in New York one can contribute up to $520,000 for one beneficiary.
While there are no annual limits to 529 plan contributions, contributions over $15,000 per year from a single parent — $30,000 for couples — may be subject to a gift tax. This means anything over $15,000 is subject to paying gift tax on that overage amount.
In terms of investment strategy, a college savings plan allows the account holder to choose from a range of investment portfolio options, as mentioned before.
These portfolios can be either static fund portfolios or age-based portfolios. The latter type shifts to a more conservative investing strategy as the beneficiary nears college age.
When choosing a portfolio, the account owner should pay attention to the timeframe in question, and make an informed decision on whether volatile or riskier investments make sense for their situation.
Finally, some 529 plans offer automatic payroll deduction, meaning contributions are made with post-tax dollars taken out of the account owner’s paycheck. This can be set up on the individual 529 plan’s website, and by providing a copy of the plan to the account holder’s employer.
529 Plans and Taxes
When used for qualified education expenses such as tuition and fees, books, computer equipment and access, withdrawals can be made from a 529 plan tax-free. It’s also possible to withdraw up to $10,000 a year tax-free for K–12 expenses.
However, if the funds are not used for qualified educational expenses — in the case where the beneficiary does not pursue higher education, for example — the funds will be subject to federal and state income taxes, with an additional 10 percent federal tax penalty on withdrawals. For this reason, account holders should be careful of overfunding the plans.
Aside from that, investing in a 529 plan often comes with special tax benefits for the account holder, depending on the state and the type of plan. Currently, most states offer tax benefits for contributions made to the account, such as deducting contributions from state income tax, tax credits, or matching grants.
Be mindful of the various restrictions imposed by the state government. Consulting with a tax professional or financial advisor is always a good strategy when opening a 529 plan.
It’s important to watch out for state and federal law changes that could affect 529 plans.
For example, The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 enabled the usage of 529 plan funds to pay for the costs of technical apprenticeships and student loans.
While this was a step in the right direction toward tackling student loan debt, the amount available to pay back student loans is limited to a lifetime figure of $10,000 of tax-free withdrawals.
529 Plans and Financial Aid
Assets held in a 529 account may impact the beneficiary’s eligibility for financial aid, though the good news is that these assets are considered property of the account holder. This means 529 contributions are counted as family assets when determining expected family contribution rather than holdings of the beneficiary.
The larger portion of financial aid packages is made up of student loans, so the more money that is saved in a 529 plan, the less debt will be incurred on the part of the beneficiary (as the assets in the account will reduce the dollar amount of student loans needed). Keep in mind that financial aid varies from educational institution to institution.
The Bottom Line
Its benefits make a 529 plan an excellent vehicle to grow wealth for future higher education costs. The plan’s tax-advantaged nature, its potential state tax credits or deductions, and tax-free growth make it a solid option for parents, grandparents, and other family members.
With no limit on contributions in a year, parents can ensure their children are set up for their future education expenses by contributing as much or as little as possible. As previously mentioned, even $50 a month can go toward a debt-free future.
Consulting with the state government where the account will be opened is a surefire way to maximize the investment potential of the account.
When opening a 529 account, make sure to do research and consult with a financial advisor about the best options available. A full list of 529 plans per state can be found on CollegeSavings.org.