A 529 plan is a tax-advantaged college savings strategy. You can use it to save for both K-12 tuition as well as college costs.
529 plans are named after an Internal Revenue Code Section 529. Earnings under 529 plans accumulate without attracting any tax. Furthermore, distributions aren’t taxed federally either when used for qualified higher education expenses. Qualified education expenses include up to $10,000 annually in K-12 tuition and also include the costs of apprenticeship programs.
Types of 529 Plans
529 plans come in two major forms. They include:
Prepaid Tuition Plans
Prepaid tuition plans give you the ability to prepay for all or part of the costs of an in-state public college education. They are offered by a few states and some higher education institutions.
These plans give you the ability to lock in tuition at current rates for any student who may not attend college for years to come. And funds in prepaid tuition plans may be converted for use in private and out-of-state colleges.
Funds saved in a prepaid tuition plan grow in value over some time, and the money is not taxable when used for tuition. However, unlike other 529 plans, prepaid tuition savings plans do not cover room and board. They may also have additional restrictions, such as specific colleges they may be used for.
College Savings Plans
College savings plans work like a Roth IRA. Your after-tax contributions go into various investments, including mutual funds. The 529 plan then grows depending on the performance of the underlying assets.
Some 529 plans offer FDIC-insured products, such as those offered by College Savings Bank, acquired by NexBank.
Some 529 plans offer target-day-funds that gradually adjust holdings by adopting a more conservative approach as the beneficiary nears college age.
Any withdrawals from a 529 savings plan can be used for qualified expenses, including tuition, fees, room, board, etc. They can also pay for registered apprenticeship program expenses and up to $10,000 in student debt repayment for account beneficiaries and siblings.
Benefits of a 529 Plan
As a college savings strategy, 529 plans offer a variety of benefits that make them ideal for savers. Some of the advantages include:
- 529 plans provide unparalleled income tax breaks. While not deductible, earnings in a 529 plan grow tax-free and will not be taxed when you withdraw money to pay for college.
- The donor stays in control of the account. Unless otherwise stated, the named beneficiary has no legal rights to the funds in a 529 account. As such, you can guarantee that the money goes to the intended purpose.
- Local states may also offer tax breaks. Over 30 states offer full or partial tax deductions or credit for 529 contributions.
- 529 plans are typically low maintenance. Set and forget through automatic payroll deduction plans.
- Minimal tax reporting is required. You do not have to report contributions on your federal tax return. Additionally, you won’t receive a Form 1099 to report earnings until you make withdrawals.
- Everyone is eligible for a 529 plan. It has no income limits, age limits, or even annual contribution limits. However, lifetime contribution limits are capped at between $235,000 – $520,000.
While there are a few drawbacks, including limited investment options; high fees charged by some, and a 10% penalty for non-qualified withdrawals, the many benefits make this a highly desirable and popular way to save for your children’s education.