An Introduction to 529 Plans

Are you currently considering setting aside money for a family member’s education? If so, a 529 plan may be your best bet. In this post, we’ll cover key details you need to know about 529 savings plans—as well as their pros and cons—and answer common questions we receive about them. Let’s dive in.

What is a 529 savings plan?

A 529 plan is an investment account that offers tax advantages when the saved funds are used for qualified educational expenses. State governments sponsor these funds, with each state boasting different options, rules, and benefits.

The main selling points of a 529 savings plan are that contributions you make can grow tax-deferred and withdrawals—when used for qualified education expenses such as tuition, books, and other related costs—are also tax-free at the federal level. Many states also offer additional tax benefits such as state income tax deductions and credits for 529 plan contributions.

While 529 plans are usually considered college funds, keep in mind you can also utilize them for K-12 and apprenticeship education costs.

Types of 529 plans and how they work

While each state may have slightly different rules and options, a 529 is typically either categorized as a college/education savings plan or a prepaid tuition plan.

College/education savings plans
Education savings plans function similarly to a Roth IRA in that they feature after-tax contributions and investments (often mutual funds or the like) grow tax-deferred.

College savings plan funds are flexible, as you can generally use them for tuition at any college or university—including eligible international schools. They can also cover college room and board expenses, offer expanded coverage for qualified K-12 school tuition (up to $10,000 per year), and be used to pay off student loans (with a $10,000 lifetime limit). Furthermore, various options are available should the account beneficiary no longer need the money due to a scholarship or college plan change—this includes shifting to a new beneficiary or rolling over a portion of unused funds to a Roth IRA account starting in 2024.

Nevertheless, a college savings plan doesn't come with any guarantees; and while you can choose your investments, they may not always perform exactly how you need them to. Consequently, it is in fact possible to lose money and fall short of your savings goals.

Prepaid tuition plans
As the name suggests, a prepaid tuition plan is a contract wherein you pay for your child's future college tuition in advance. You can do so via a lump sum or regular installments, using after-tax money to purchase "units" or "credits" with either option.

The price of these credits is determined prior to purchase and varies based on the current age of the beneficiary, estimated cost of tuition, and projected rate of return. With prepaid plans, you don't personally choose any investment options; instead, plan administrators (state governments) pool the money and make investment decisions on your behalf.

One appealing feature of prepaid accounts is that they protect you from tuition inflation, as most states guarantee funds will cover future tuition rates. This is especially important when you consider a recent report from the Education Data Initiative, a research organization, claiming college tuition inflation averaged 12% annually from 2010 to 2022.

Unlike many alternative investment options, prepaid tuition plans offer high contribution limits (set by each state): allowing you to pay enough to purchase all necessary credits.

You also won’t lose money if your child decides to attend an out-of-state school, as plan benefits can be applied to any eligible institution. Moreover, you can request a refund on your prepaid account should you no longer need the money.

Finally, know that prepaid plans are only available to residents of that same state and generally feature limited enrollment periods.

One additional option known as a “private college 529 plan” (also referred to as a “private prepaid tuition plan”) exists within the prepaid plan category, the biggest difference of which is that it is sponsored by hundreds of nationwide private colleges and universities and doesn’t include state residency requirements.

With respect to how prepaid tuition plans work, the buyer purchases tuition “certificates” to redeem at any participating college. Contributions grow tax-deferred, and withdrawals are tax-free when used for qualified education expenses. As with state-administered plans, flexibility does exist should you ultimately not require the funds; this includes naming a new beneficiary or requesting a refund.

Prepaid tuition plans are guaranteed by participating schools despite any tuition increases over time but do not offer year-round open enrollment like their private college 529 plan counterparts.

529 plan contribution limits

Contribution limits for 529 plans are not uniform across states but are typically quite generous (often falling somewhere between $235,000 and $529,000). The federal government sets no annual contribution limit, but lifetime contribution limits do vary from state to state. Furthermore, you can invest as much as you want, whenever you want after making an initial contribution.

529 plan contributions are also considered gifts (for tax purposes), up to $17,000 per beneficiary in 2023. For example, if you’re married and have two kids, you and your spouse can jointly give $68,000 without triggering the federal gift tax. Any excess contributions, however, will count against your lifetime estate and gift tax exemption of $12.92 million.

The IRS does offer a special five-year "front-loading" rule, allowing you to make a one-time gift of up to $85,000 ($170,000 for couples filing jointly) without incurring gift taxes—provided you don't make additional contributions for the next five years. This action is often referred to as “superfunding” or “5-year gift tax averaging” and employed as an estate-tax planning strategy.

Common questions about 529 plans, answered

What if the beneficiary does not eventually enroll in school?
Contrary to some inaccurate sources, if the intended recipient of your 529 college savings plan decides not to pursue higher education (or receives a full or partial scholarship—congratulations!), you do have some options in this regard.

For starters, you can change the beneficiary on the account to another qualifying family member. This extends to another child, grandchildren, stepsiblings, foster/adopted children, nieces and nephews, aunts and uncles, first cousins, and in-laws (son, daughter, father, etc.). You can also personally use the funds to complete a degree or learn new skills.

You can also make non-qualified withdrawals for any unused funds in the account. These contributions won't be taxed or penalized in this scenario as they were made with after-tax dollars. However, the earnings portion of your distribution will incur taxes and a 10% penalty (note that California imposes an additional 2.5% state income tax). As with any rule, exceptions to this 10% penalty do exist; for example, if the beneficiary of the 529 plan becomes disabled or passes away, educational assistance is still possible via a qualifying employer program or U.S. military academy attendance (waiving the 10% penalty).

A third option—which becomes available on January 1, 2024 thanks to the SECURE 2.0 ACT—is to transfer leftover funds (provided the account has been opened for 15 years) to a Roth IRA for that same beneficiary (just note the rollover amount cannot exceed annual IRA contribution limits and must have existed in the 529 account for at least five years). There’s also a $35,000-lifetime cap on Roth IRA rollovers for each 529 account beneficiary.

How does a 529 plan impact financial aid?
In most cases, assets held in a 529 plan owned by a parent or student have minimal impact on financial aid eligibility. They also receive favorable FAFSA (Free Application for Student Aid) treatment, and distributions aren’t reported. Beginning in 2024-2025, FAFSA plans owned by grandparents or other family members will not adversely impact financial aid eligibility.

Which expenses are not qualified under a 529 plan?
While 529 plans offer a broad range of qualified educational expenses, some costs are not covered. One example is transportation; if you need to buy a plane ticket or fuel up your car to transport your student to school, those costs are not qualified expenses under a 529 plan. Health insurance and medical expenses also do not qualify—even if required by the institution—nor do extracurricular activities, clubs, and trips unrelated to the educational program.

While room and board are qualified expenses, specific limitations do exist. For example, students who live off-campus are subject to limits regarding how much they can spend on rent or apply to a meal plan. Every school has its own proprietary figures detailing how much it should cost a student to attend, with these numbers either published on their website or provided upon request; any room and board costs that exceed these cost-of-attendance figures will not be qualified under a 529 plan.

In sum: are 529 plans worth it?

The answer to this question ultimately depends on your own unique situation. On the plus side, 529 plans offer unmatched tax advantages for qualified education expenses. They also boast high contribution limits and have little impact on federal financial aid calculations. Additionally, you can personally maintain control of the account and change the beneficiary to another family member in the absence of any corresponding penalties.

However, these plans are not without some downsides; non-qualified withdrawals are penalized, investment options can be limited, and you’re left with fewer options if the beneficiary decides not to pursue higher education. All of this means you’ll want to carefully assess your own personal situation and decide what’s best for you!

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.