What is a 529 plan

As I discussed last month, a 529 plan is a great way to save for your children’s future. However, many people may not know what a 529 plan is and what kind of benefits it offers to you and your children. Below is a high level summary of what a 529 plan is. Please feel free to include any questions or experiences with 529 plans in the comments section below.

A 529 plan is a tax-advantaged savings plan designed to encourage and incentivize saving for future education costs. They can offer a variety of tax and other financial aid benefits.  529 plans are sponsored by states, state agencies, or educational institutions. There are primarily two types of 529 plans: (1) college savings plans and (2) prepaid tuition plans. I believe every state has at least one 529 plan to offer and there are plans that are operated by colleges and universities as well.

Two types of plans

• College Savings Plans: College savings plans allow an individual to open an investment account to save for future qualified higher education expenses. Qualified education expenses can include tuition, mandatory fees and room & board. Withdrawals can be used at any college or university. They can also be used to pay up to $10,000 per year for institution at any elementary or secondary school. When you open the account and begin saving, the individual can typically choose a range of investment portfolio options, including mutual funds, exchange-traded funds (ETF), and guaranteed return products. These investment options also may include age-based investment products, which are also called target-date portfolios. Typically age-based portfolios automatically shift toward more conservative investments as the beneficiary gets closer to age where you need to withdrawal the money to spend on education expenses. Lastly, the College Savings Plans are sponsored by a state government, and a few may have residency requirements.
• Prepaid Tuition Plans: Prepaid tuition plans lets an individual pre-purchase units or credits at participating colleges and universities. These are usually public universities or in-state colleges. These credits can be used for future tuition and the tuition is locked in. However, the credits typically do not pay for future room and board and doesn’t allow you to prepay for tuition for elementary schools. Lastly, the Prepaid Tuition Plans are sponsored by a state government, and a few may have residency requirements. Also some prepaid plans are not guaranteed by the government, and if the plan’s sponsor has a financial shortfall, you may lose your prepaid investment. 

Contributions: Contributions into the 529 plan are not tax deductible from federal income taxes. However there are over 25+ states that offer state income tax deductions/tax credits for contributions to 529 plans so make sure to check out your state if it offers tax deductions.

Withdrawals: I would highlight the investment account offers tax-free earnings growth and tax-free withdrawals only when the funds are used to pay for qualified education expenses. This includes tuition, fees, books, supplies, equipment, computers and sometimes room and board. The IRS also allows tax-free withdrawals of up to $10,000 per year, per beneficiary to pay for tuition expenses at private, public and religious K-12 schools. However if you withdrawal money that is not used for qualified education expenses, the earnings will be subject to ordinary income taxes and a 10% penalty!

Using your 529 plan: Once you have upcoming education expenses and you are ready to start taking withdrawals from a 529 plan, you can likely distribute the payments directly to the school. Some plans may allow you to make a payment directly from your 529 account to another third party, such as a landlord. Make sure you ask about how to make withdrawals prior to doing so.

If the money is not used: If you do not use the money in a 529 plan, there are several options to avoid the tax penalties. You can change the beneficiary to another qualifying family member, you can donate the money to people specifically for people living with disabilities, and/or you can wait until the beneficiary has future education expenses.

Overall Benefits

As I discuss above, there are a number of benefits to 529 plans. These include:

• Investments grow tax free and the withdrawals will not be taxed when the money is taken out to pay for education expenses. 
• Many states offer tax deductions/credits. Be sure to research all options and see if the state you reside offers tax incentives.
• It is easy to set up, and you can control the account. The account is very similar to opening a bank account or a regular investment account. It is very hands off and a very easy way to help you save for future education expenses.
• Minimal restrictions: There are minimal restrictions and everyone is eligible to take advantage of a 539 plan. 

Please feel free to comment if you have any experience setting up or using a 529 plan!