Basic Overview of Section 529 College Savings Plans
Rules and Guidelines for Section 529 Plans
Few things excite parents, relatives, financial planners, and college-bound students like the availability of Section 529 College Savings Plans. While these accounts do not make money for college expenses magically appear—you still need to save funds diligently over a long period of time—they do make the management of that money easier and more effective while providing a few tax benefits to boost.
The greatest benefit, though, comes when it is time for the student to start applying to colleges. Knowing that there is money already saved for this purpose makes the whole process of applying for financial aid and searching for scholarships much less stressful.
Prior to the advent of Section 529 plans, parents who wanted to save for their child’s college education had few options. These options were basically limited by whether the child’s name or the parents’ went on the account.
Everything changed in 1996 when Congress passed the Small Business Job Protection Act. As a provision of this act, Section 529 college accounts were created. These accounts offer parents attractive tax benefits for saving money toward college and still allow them to retain permanent control over the assets.
Although these plans offer many benefits, there are some crucial points to be aware of when considering 529 plans to help save for college.
Benefits and Eligibility
The eligibility rules surrounding Section 529 plans are much more liberal than those surrounding other savings vehicles like Roth IRAs. Anyone can contribute to a Section 529 plan, regardless of how much money they make; however, they do need to be aware of U.S. gift tax limitations and understand how larger gifts may affect their eventual estate taxation.
Parents and others who want to help put money aside for college expenses use these tax-advantaged investment accounts, knowing that any increase in those assets is free of federal and state income taxes.
All withdrawals used for qualified higher education expenses are exempt from federal income taxes. State taxes are waived on withdrawals in 33 states and the District of Columbia, with some also offering other incentives.
Upon opening a Section 529 account, the parent or account owner is required to designate a beneficiary. This “designated beneficiary” is usually the student who will eventually attend college.
When distributions are made from the account for qualified educational expenses for this beneficiary, there is no taxation on growth of the original investment. Educational expenses are broadly defined in Section 529 plans and can include things like uniforms, books, and even transportation.
If any of the account's distributions are not considered qualified, meaning that the money was spent on non-education-related items, then federal income tax will be due on the growth of the distributed investments and can also incur a 10% penalty.
If a designated beneficiary does not go to college, or money remains unused, the parent or account owner can change the beneficiary—to a brother or niece, for example. The IRS rules are extremely flexible and allow the beneficiary to be changed to any immediate family member, as well as descendants of the original beneficiary.
Effects on Financial Aid Eligibility
A Section 529 account is generally considered an asset of the parent, which means that 5.6% of the value is expected to be used toward college. This provides a significant advantage over UGMA/UTMA custodial accounts, which require that 20% of the assets be used toward college.
Section 529 Providers
Each state’s 529 plan is a little different, and many states use different investment managers to oversee fund assets. Your investment options are usually limited to the mutual funds offered within each unique plan. While you can generally use any plan to go to college in any state, you should check into whether or not certain state income tax benefits might apply to you.
Wrapping It Up
Section 529 College Savings plans should be at the top of the list for parents and others wanting to save for a loved one’s education. While there are some rules to follow, the tax benefits and ownership flexibility of these plans make them well worth it. Plus, you will eventually have the satisfaction of seeing the student you helped walk across that stage and receive a diploma come graduation time.