529 plan funds can grow federally tax-free when used for qualified expenses
The SECURE Act of 2019 expanded the list of qualified expenses, including apprenticeships and student loans
Contribute up to $75,000 all at once without paying the gift tax
It’s no secret that the cost of college has been on the rise. Depending on your course of study, it’s gone up quite a bit, a ton, or an astronomical amount. No matter how you slice it, college costs have outpaced inflation and wage growth.
But depending on which career path you and your loved ones choose to pursue, a college education is a near-necessity. Many careers require advanced degrees, and pretty much any skilled career requires vocational training and certification over and above a high school education.
If you’re concerned about covering the costs, one of the tools you can use to invest toward higher education is the 529 plan, which is a tax-advantaged investment account designed specifically to help cover education expenses.
So, what is a 529 plan? Read on to find out how the 529 might fit into your plan for saving for college.
What Is a 529 Plan?
A 529 plan is a tax-advantaged investment account designed to reward investors when they save for education expenses. On a federal tax level, you contribute after-tax money and your investments can grow tax-free as long as you withdraw money only for 529 plan qualified expenses. Plus, in some states, you can get a state income tax deduction (or even a credit) when you contribute to a 529 plan. Check your state’s specific 529 rules before filing your tax return.
Because your money is invested, you have the chance for it to grow over time. When you consider that college costs have been increasing faster than the rate of inflation, a 529 plan becomes more attractive because you can take advantage of potential compounding returns.
What Are the Pros and Cons of a 529 Plan?
There are several potential benefits of a 529 plan:
- Tax advantages. Although you won’t get a federal tax deduction for your contributions, any growth of your investments do so federally tax-free as long as you use withdrawals only for 529 plan qualified expenses. In contrast, when you make withdrawals from a brokerage account, you might have to pay capital gains taxes on your earnings.Change beneficiaries. Has Junior decided to forgo college? You can switch the beneficiary to someone else—including yourself. This also works if there’s money left over after one child finishes school. You can change the beneficiary to another qualifying member of the family, such as a sibling or first cousin.Maintain control. As the account owner, you’re in control of how the funds are used. Your child can’t just abscond to Europe with the money.Avoid the gift tax. For 2020, you can give up to $15,000 to another person and avoid paying the gift tax. But a 529 lets you pack five years into one 529 contribution. You can give up to $75,000 as a lump sum and avoid the gift tax for that year. However, you have to wait until year six if you want to contribute again without incurring gift taxes. These numbers double for married couples.
There are some potential drawbacks to a 529 plan:
- Penalties for some withdrawals. If withdrawn money isn’t used for 529 plan qualified expenses, it’s subject to a 10% penalty and applicable taxes. Fewer investment choices. Your investment choices are limited to those selected by the plan’s administrator. You might have fewer choices than with a brokerage account or self-directed Coverdell Education Savings Account.Investment changes are limited. In addition to limited investment choices, your 529 plan only allows you to make changes for existing dollars twice in a calendar year.
How to Stretch Your 529 Dollars
Work toward a degree—and some potential tax savings.
Investing in a 529 savings plan can go a long way toward helping you cover various expenses for your student. You can use the money for qualified expenses, such as:
- TuitionRoom and boardBooksNecessary equipment (like a computer)Up to $10,000 for tuition at K-12 schools (not available with all plans; check first)
The passage of the SECURE Act in December 2019 expanded 529 benefits to include fees, books, equipment, and supplies for certain apprenticeship programs. Also, under the SECURE Act, a 529 may be used to repay student loans—up to a $10,000 lifetime limit—for the 529 beneficiary and/or his or her siblings. (Check your plan to confirm if apprenticeships and student loan repayments are eligible.)
Depending on your situation, you can stretch your 529 dollars. First of all, if your child gets a scholarship, you can actually withdraw the scholarship amount from your 529 for nonqualified uses without paying the 10% penalty. You’re still required to pay taxes on the earnings portion of your withdrawal, but you avoid the penalty.
You can also take steps to ensure that your 529 dollars go further. For example, if your student starts at a community college, they can save money on tuition and other costs. Plus, if they live with you for part of their schooling, money from the 529 doesn’t have to be used for room and board.
Don’t Put Your Own Financial Goals at Risk
If you decide a 529 plan is the way to go when investing toward college, don’t put your own financial future at risk. You’ll often hear: “There are loans for college; there are no loans for retirement.”
So consider setting money aside for other goals, like retirement, before putting too much money into a 529 plan. Think carefully about what’s likely to work best for you in the long run. Of course, it’s possible to save for multiple goals at once, but work toward meeting your own needs first.
The earlier you start investing in a 529 plan, the less you may need to set aside to help your student with their goals. By opening an account early and setting up a regular schedule of contributions, it’s possible to let potential compounding returns increase the chances that you’ll be able to help your child get through college with as little debt as possible.
An investor should consider a 529 plan’s investment objectives, risks, charges and expenses before investing. A plan’s Program Disclosure Statement, which contains this and more information, should be read carefully before investing. Investors should consider before investing whether their or their beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program and should consult their tax advisor, attorney and/or other advisor regarding their specific legal, investment or tax situation.