Funding college is a great concern for parents, grandparents, and other loved ones. A smart investment like a Section 529 savings account can help you build on your assets and save more money for your child's college.
This beginner's guide will give you a good overview of the advantages and disadvantages involved in a Section 529 plan. If you believe it is something you wish to pursue further, discuss the option with your financial planner to get the latest details for your state and receive help in deciding whether it is a good option for your family.
What Is a Section 529 Savings Plan?
Section 529 plans are considered one of the best options for saving for a child’s college education. They are called “Section 529” plans after the specific IRS code that permits their use.
There are two types of Section 529 plans: savings accounts, and prepaid tuition plans. This article specifically reviews Section 529 savings accounts.
The Section 529 savings account allows for after-tax contributions to be made on behalf of a designated beneficiary (not just a child). These contributions are allowed to grow tax-deferred and can potentially be withdrawn tax-free for qualified educational expenses.
Who Is the Ideal Investor for a Section 529 Savings Plan?
A Section 529 savings plan is ideal for parents or grandparents who have some combination of the following factors:
- You would like to save more than $2,000 per year and
- You make enough money to be disqualified from using a Coverdell ESA.
- You want the freedom to reclaim the assets for any reason you choose.
- You live in a state that offers a state income tax deduction for contributing to a Section 529 plan.
- You have multiple children with the hope that all will attend college.
- You start planning for college late in the children’s lives.
- You are planning to save large amounts of money towards college costs.
- You expect your children to attend expensive graduate programs.
- You would like to fund a loved one’s college while significantly reducing the size of your own estate.
The tax-deferred growth and potential tax-free withdrawals associated with Section 529 make it very attractive to individuals who want to maximize the growth of their college savings.
While other plans (such as the Coverdell ESA) offer this feature, Section 529 allows a parent or donor to remain in control of the assets indefinitely. It even allows them to close the plan and get their money back (subject to taxes and penalties).
Additionally, Section 529 plans provide for in-state income tax deductions in 34 states and Washington D.C. They can also be shielded from a number of state’s financial aid calculations.
While there are fewer downsides to the Section 529 plans than many other accounts, there are still some to be aware of. The biggest is that distributions from Section 529 plans for pre-college expenses (grades K-12) are limited as qualified education expenditures.
Additionally, the investment options in a Section 529 plan are limited to what the state offers in mutual funds, and in some cases, exchange-traded funds and/or certificates of deposit. Other types of accounts have almost the entire financial fund universe available for purchase.
What Are Your Investment Options?
Section 529 savings plans have a preset menu of mutual fund investment choices. Most often, a state’s Section 529 plan will contract with a mutual fund company to manage the plan. In turn, this company’s mutual funds will be the extent of available investment choices.
Many of the Section 529 savings plans offer “age-based” investment options, which allocate your investment between stock, bond, and money market funds based on your child’s age. As they get older, the fund becomes more conservative in its investment mix.
You are permitted to change your investment strategy twice per calendar year. Exceptions are made if you move your assets from one state’s plan to another or roll the Section 529 plan over to a new beneficiary.
What Are the Tax Benefits?
The biggest tax benefit of the Section 529 plan is that it allows for the tax-deferred accumulation and tax-free withdrawals for qualified expenses. In other words, you do not have to pay tax on any of the annual growth of your original investment if the money is used for education.
There is no Federal “tax deduction” for putting money into a Section 529 plan. Contributions are made with “after-tax” dollars and will not lower what you owe the IRS.
However, 34 states and the District of Columbia offer an income tax deduction to their residents for funding a Section 529 plan. Often, this deduction is limited to using your state’s plan.
Additionally, Section 529 plans allow for some fairly advanced estate tax planning strategies for families trying to avoid inheritance taxes.
What Are the Eligible Expenses?
An account owner may initiate a tax-free distribution on behalf of the beneficiary for “qualified” college or graduate school expenses (in most states). Unlike the Coverdell ESA, qualified expenses for elementary and secondary education are limited in the Section 529 plans.
The IRS rules for Section 529 qualified higher education expenses, while still being fairly liberal, are more strict than the Coverdell as well:
- Room and board (student must be enrolled at least half-time)
- Computers or laptops (only if the school requires them)
- Books and supplies (as required by the university)
How Does Section 529 Impact Federal Financial Aid Eligibility?
Section 529 savings accounts have a minimal effect on Federal financial aid, as they are considered an asset of the parent. As such, up to 5.64% of their value is counted against financial aid eligibility.
If the owner is a grandparent, a member of the extended family, or an unrelated individual, it is argued that the assets do not count against financial aid at all. This is because there is no place to report assets owned by people other than a parent or student on the FAFSA form. However, students are required to report any distributions received from a 529 plan owned by someone other than themselves or their parents or legal guardian.
Section 529 savings plans have the most flexible eligibility rules of any college savings vehicle. In essence, anyone can open and contribute to a Section 529 plan on behalf of anyone else, without regard to the age, income, or relationship of either party.
The only limit placed on contribution amounts is a “lifetime limit” per recipient, which is set by each individual state. This limit is meant to keep individuals from dramatically over-funding college savings account beyond what is realistically needed. This lifetime limit ranges from $300,000 and up, varying from state to state.
Additionally, contributors need to be aware of gift tax rules regarding larger contributions. Normally, a gift of over $15,000 to anyone besides your spouse will require you to file a gift tax return for that year.
Within Section 529 plans, there is a special provision that allows individuals to make five years’ worth of contributions ($75,000 per adult or spouse) into the plan in one year for one beneficiary, without owing a gift tax on the amount.
- A gift of this amount requires a special election to be made on a IRS Form 709 in the year of the initial gift.
- Any additional gifts to that person in the following five years, even if not into the Section 529 plan, will likely trigger a gift tax on the excess amount.
There is no deadline for contributing to a Section 529 plan.
There are no taxes or penalties on withdrawals made to fund educational expenses, as long as the withdrawal doesn’t exceed the actual amount of qualified expenses. If excess funds are withdrawn, a portion will be subject to taxation and a 10% penalty (this may be waived in certain cases).
Treatment of Unused Funds
There are no rules or age limits on when Section 529 funds have to be used. If there is no longer a need for a Section 529 plan for an individual, it can be rolled over to another future student's account. This includes immediate family members of the original beneficiary, parents, cousins, aunts, and uncles, and in-laws.