This is Part 3 of the Investing for Your Children Series. Read parts 1 and 2!
Part 1: Custodial Accounts (UTMA/UGMA)
Part 2: IRAs
Contents
The cost of obtaining a college degree has risen by more than 65% since 2001. Without a plan and consistent action, the hopes of our children graduating college with no debt is nothing more than a thought. A 529 plan could be the solution to ensuring your child can attend college without the burden of loans for the rest of their lives. Here is everything you need to know about 529 plans.
What are 529 Plans?
529 plans are state-operated investment plans designed to give families a way to save money for college with substantial tax benefits. With the passage of the Tax Cuts and Jobs Act of 2017, these plans can be used for K-12 private school expenses as well.
What types of 529 plans are there?
Most states sponsor two types of 529 plans. Prepaid Tuition Plans and College Savings Plans
Prepaid Tuition Plans
Prepaid tuition plans allow you to to prepay tuition at participating colleges and universities. Some states allow room and board to be prepaid as well. The basic concept is: the child can attend college in the future at today’s prices. The ability to avoid rising education costs is an attractive feature but not without any downside. In this plan, you purchase credits that cover future education costs.
Most prepaid tuition plans require residency in the state that is administering the plan. If you live in Virginia and select a prepaid 529 plan, your child will be restricted to attending a Virginia state college to have the full benefit from the prices you locked in with the plan. (Check your specific state’s prepaid plan’s rules.)
College Savings Plans
College savings plans are straightforward. They operate just like a custodial account in that the account holder invests on behalf of the named beneficiary. You invest in index and mutual funds. Similar to a Roth IRA, the capital gains free when withdrawn spent on qualified educational expenses.
Unlike the prepaid tuition plans, there is no in-state restriction as the money isn’t tied to credits established by a particular state.
The typical plan offers a number of investment options, including stock mutual funds, bond mutual funds, and money market funds. A very popular option is the age-based portfolio that automatically shifts toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any college or university regardless of the state carrying the plan of the state of residence.
The Difference Between the two 529 Plans
Difference | Prepaid Tuition Plan | College Savings Plan |
|---|---|---|
Tuition/Education Costs | Locks in tuition prices at eligible public and private colleges and universities for in-state colleges of the state of your residency. | No lock on college costs. |
Qualified Expenses | All plans cover tuition and mandatory fees only. Some plans allow families to purchase a room and board option or use excess tuition credits for other qualified expenses. | Covers all qualified higher education expenses, including the following: |
State Guarantee | Many state plans are guaranteed or backed by the state. | No state guarantee. Most investment options are subject to market risk. Your investment may make no profit or even decline in value. |
Age Limits | Most plans have age/grade limits for beneficiaries. | No age limits. Open to audits and children. |
State Resident Requirement | Most state plans require either the owner or beneficiary of the plan to be state resident. | No residency requirement. However, nonresidents may only be able to purchase some plans through financial advisers or brokers. |
When can you enroll? | Most plans have limited enrollment period | Enrollment is open all year. |
Source: Smart Savings for College, FINRA
Who can open a 529 plan?
Anyone 18 and over can open a 529 plan. Generally, they are established by parents or grandparents on behalf of a child (the account’s beneficiary).
You don’t have to be related to the beneficiary to open an account for them. You can even open account and name yourself as the beneficiary.
What are the qualified expenses?
There are no penalties and typically no taxes on withdrawals if the funds are used for the following.
Tuition
Fees
Books
Supplies and equipment
Computers and software
Internet access
Note: All expenses must be mandatory for registration and attendance at the educational institution.
Other Qualified Expenses
All expenses listed above for K-12 education, up to $10k per year.
Apprenticeship fees for programs registered with the Secretary of Labor.
How much can I contribute?
There is no contribution limit to a 529. Anybody can contribute as much as they want to a plan up to the total plan aggregate limits (noted below for each state). However, there are gift tax considerations for contributions over $19k, annually.
Married couples count as separate donors. That means they could give $38k to a child’s 529 plan annually without triggering the gift tax.
The IRS allows a 5-year front-load contribution to 529 plans. This means $90k ($18k 5 years) can be contributed at once without triggering the gift tax. The front-load contribution disallows any more contributions to the plan for the next 5 years. Married couples can front-load up to $180k per child ($36k * 5 years). If there are any contributions made in the next 5 years after a max front-load contribution, you must report those amounts on a gift tax return.
How are 529 plans taxed?
Contributions made to a 529 plan are state tax-free for most states, but not federal tax-free. You’ll need to claim your state tax benefit on your state income tax, noting the amount you contributed. Most states allow up to $5k of your contributions to be tax free.
As long as the withdrawals are to cover qualified education expenses of the named beneficiary, the withdrawals are also tax-free. However, the capital gains from the investments withdrawn from a 529 plan for ineligible expenses will be subject to income tax and an additional 10% federal tax penalty.
Action | Tax Treatment |
|---|---|
Contributions | Federal - no deductions for contributions. |
Earnings | The earnings on the investment are tax and penalty free if used for qualified expenses when withdrawn. |
Withdrawals | Typically, no tax if used for qualified expenses. |
Transfers | No for transfers to members of immediate family. (more on that below) |
Note: If any taxes applied, it will be the student responsible for the taxes as they are the beneficiary of the plan. The donor is off the hook.