Investing in Their Future:

How a 529 Plan Can Help You Save for College

🕒 7-minute read

If you’re worried about how you’re going to pay for your child’s college education, a 529 Savings Plan is a great way to save smarter, not harder. This type of plan allows you to save money for a child’s education in an individual investment account. Unlike other savings plans, 529 plans are qualified tuition programs specifically designed for education and come with unique tax advantages. Depending on the plan and applicable law, 529 savings plans may also be used for a variety of education expenses, including certain elementary, secondary, and higher education costs. They are established by states and usually managed by an experienced financial institution designated by the state. While the details of 529 Plans vary by state, the basics are the same.

How it Works

• You, another parent, grandparent, or anyone else can open an account and name a beneficiary, who does not have to be related to the account owner. A 529 savings plan can have only one account owner and one beneficiary at a time. As the account owner, you decide when contributions and withdrawals are made.
• Once the account is open, the owner (or anyone else) can contribute as much money to the account as they wish, subject to the plan’s specific limits. Some plans may require a minimum amount to initially open the account or a minimum amount per contribution. Plans may also restrict the total contributions allowed in one year. All plans have total lifetime contribution limits, but those limits are high, with most states generally having limits over $350,000. Typically, you can contribute in a lump sum upfront, on a five-year plan, or with fixed monthly payments.
• When you make a contribution, your money goes into one or more of the plan’s investment portfolios that you select. You will typically have a variety of portfolios with different amounts of risk to choose from.
• When you need funds for the beneficiary’s education expenses, you can notify your financial institution’s 529 plan administrator that you’d like to make a withdrawal. Withdrawals used for qualified education expenses are generally tax-free at the federal level, but non-qualified withdrawals may be subject to taxes and penalties. 

 

Now that you know how the plan works, let’s explore eligible expenses covered by a 529 plan.

 

Qualified and Non-Qualified Expenses

It’s important to know exactly what’s covered by a 529 savings plan, as using the plan to pay for non-qualified costs can lead to tax penalties.

Qualified expenses are amounts used to pay for tuition, fees, and certain education-related expenses required for enrollment or attendance at an eligible educational institution. These include tuition, mandatory fees, books, supplies, equipment required for courses, and, when the student is enrolled at least half-time, room and board. Funds can typically be used for college expenses, whether your student is full-time or part-time. Check with your plan administrator for details, including the rules for using 529 funds for housing and food.

Non-qualified expenses are those not covered by 529 plans, such as insurance, medical expenses (including student health fees), transportation, personal living, and family expenses. Using the account for these expenses may result in taxes and penalties.

An exception is the American Opportunity Tax Credit (ATOC), which covers the cost of books, supplies, and equipment for a course, even if they don’t buy it from an on-campus vendor. To claim this tax credit, you or your dependent must file a tax return with Form 1098-T, which you receive from the vendor. To be eligible to claim the AOTC, the federal tax law requires you or your dependent to have received the form from an eligible education institution, domestic or foreign. Covered expenses are room and board, insurance, medical expenses (including student health fees), transportation, and personal living or family expenses.

 

Pros and Cons

529 savings plans are extremely popular due to their unique combination of advantages, but they also come with some tradeoffs. Let’s take a look at their strengths and weaknesses:

Strengths

• Contributions grow tax-deferred. The money you contribute to your account grows income tax-deferred at both the federal and state levels. This means that instead of paying income tax each year on the money the account earns (if any), income taxes are deferred until the time you make a withdrawal.
• Withdrawals used for qualified expenses are tax-free at the federal level. Earnings on money invested in a 529 savings plan are completely free from federal income taxes as long as the funds are used to pay for the beneficiary’s education expenses. However, contributions aren’t deductible at the federal level.
• Contributions receive favorable federal gift and estate tax treatment. Contributions to a 529 savings plan are considered completed, present-interest gifts for federal gift tax purposes. That means they qualify for the federal annual gift tax exclusion. Also, your plan contributions aren’t considered part of your estate for federal estate tax purposes, even though you retain control over the account while you’re alive.
• Funds can be used at virtually any school. Money in a 529 college savings plan can be used to pay the full cost (tuition, fees, housing, food, books, supplies) at any accredited college or graduate school in the U.S. or abroad. This includes a wide variety of schools: undergraduate colleges, graduate and professional schools, two-year colleges, technical and trade schools, and foreign colleges. This is a notable advantage over prepaid tuition plans, which usually only offer benefits if your child attends an in-state public college or a college that otherwise participates in the prepaid tuition plan.
• Funds in a 529 college savings plan can also be used to pay for certified apprenticeship programs, K-12 tuition expenses up to $10,000 per year for enrollment at an elementary or secondary public, private, or religious school (except for homeschool), and to fund a Roth IRA for the beneficiary up to a $35,000 lifetime cap.
• Most plans are open to residents of any state. Nearly all states offer 529 savings plans, and the majority of plans are open to residents of any state. This means you can shop around for the plan with the best money manager, overall performance record, investment options, fees, and customer service. While each state offers tax incentives on contributions and withdrawals, such as deductions or credits for contributions or full or partial exemption of earnings from state income tax, some states may limit their tax benefits to individuals who participate in the in-state plan. States may also decide to treat college contributions and withdrawals differently from those used for K-12. Make sure you understand your state’s rules.
• It’s easy. For college investors who are too busy or inexperienced to choose their own investments, 529 savings plans offer professional money management. Opening an account is also simple. You fill out a short application, designate a beneficiary, and contribute the required minimum amount. Most plans offer automatic payroll deduction or electronic funds transfers to make saving for the future even easier.

 

• You have a rollover option once every 12 months. You can roll over your existing savings plan account to a new 529 plan account once every 12 months without any federal tax penalty and without having to change the beneficiary. This option lets you leave a plan with few investment options or one that has poor returns for a plan with more flexibility and a better track record.

Weaknesses

• Returns aren’t guaranteed. A 529 savings plan doesn’t guarantee you a minimum rate of return. In fact, the plan’s money manager may make investment decisions that lag behind the market or cause you to lose money. If you’re looking for a guaranteed minimum rate of return tied to the rate of college inflation, you might consider a prepaid tuition plan instead. Your financial advisor can help you decide what’s best for you.
• There is limited ability to change investment options on existing balances. If you’re unhappy with the performance of your current investment portfolio but don’t want to completely switch plans (like the aforementioned rollover option), 529 savings plans are federally authorized (but not required) to let you change the investment options on your existing contributions only twice per calendar year.
• Withdrawals that aren’t used for qualified expenses are taxed and penalized. Remember that if you make a non-qualified withdrawal, the earnings portion of the withdrawal will be taxed at the federal level at the rate of the person who receives the distribution (usually the account owner). State taxes will likely also apply.

You’ll also be penalized. Specifically, the earnings portion of the withdrawal will be subject to a 10% federal penalty. The same goes for prepaid tuition plans, FYI.

• There are fees and expenses. Fees and expenses are usually associated with opening and/or maintaining a 529 account. Examples are annual maintenance and administration fees, and expenses based on a percentage of your total account value.

The Bottom Line

Funding an education for your child or other family member can seem overwhelming, but the best time to start saving is now. With a 529 savings plan, saving is easier and tailor-made to offer tax-free growth on funds you can use for a variety of education expenses at almost any school. Schedule an appointment with an Osaic Institutions financial advisor today, and let us help you decide if a 529 plan is right for you. No matter which savings plan you choose, we’ll always help you make every dollar count.

 

Investment and insurance products and services are offered through Osaic Institutions, Inc., Member FINRA/SIPC. Osaic Institutions and Rave Financial are not affiliated. Products and services made available through Osaic Institutions are not insured by the NCUA or any other agency of the United States and are not deposits or obligations of nor guaranteed or insured by any credit union or credit union affiliate. These products are subject to investment risk, including the possible loss of principal. The past performance of any investment product should not be considered an indication of future results.

The tax benefits described herein depend on your individual circumstances and state of residence. You should consult a qualified tax advisor for advice specific to your situation.

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