Need to learn more about 529s? This in-depth guide will tell you everything you want to know about these accounts and then some.
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A 529 is an education savings plan governed by the federal tax code’s section 529. It’s essentially a way that the government helps parents (and other involved adults) save for a child’s education.
A 529 is similar to a tax-advantaged retirement account. The account owners don’t pay taxes on the account’s earnings so long as the money is used for qualified educational expenses. That small savings on the earnings can turn into a huge savings boost over years of compounding interest.
To earn these tax savings, you must use the funds in a 529 account for qualified educational expenses only. Because of recent updates to the law, these expenses can include a variety of higher education expenses plus up to $10,000 per year in private K-12 expenses. Using the money for other items could mean a big bill for taxes and penalties on the earnings from your account.
Most 529 plans are run by individual states, though some are run by independent organizations. In all, you have more than 100 different plans to choose from. You don’t have to work with your state’s 529 (though there may be some benefits to doing so), and it’s important to choose the best plan for your particular needs.
The bottom line is that 529 plans can be an excellent way for parents and other friends and family members to save for a child’s education. But before you run out and open one, be sure you understand exactly how a 529 works and how to choose the best account for your family.
Anyone who has reached the “age of majority,” usually 18, but in some states it’s 19 or at high school graduation, can open a 529 account. But the account owner doesn’t have to be the beneficiary. In fact, this is typically the case, as 529s were meant to be a way for parents and other adults to save for a child’s future education.
In fact, you can open a 529 (or several) and make anyone the beneficiary: your child, your grandchild, yourself, your spouse, or even a family friend. You must designate a beneficiary, which you can change later. All you need is the beneficiary’s Social Security number.
Before you decide to open an account, you need to understand the tax and financial aid implications of different 529 account arrangements.
This article goes into much more depth about how the government calculates federal financial aid eligibility and how to get the best aid outcomes. Here, we’ll just touch on the basics.
The biggest determinants of financial aid eligibility are, of course, income and assets. Both parental income and student income count in the Free Application for Federal Student Aid (FAFSA) students fill out to become eligible for government grants and loans.
However, student income counts more toward aid than parental income in the Expected Family Contribution (EFC) the FAFSA form generates. Parents are expected to put 5.6 percent of their income and assets toward higher education costs. Students are expected to put 20 percent of their assets and 50 percent of their income toward their own schooling.
This means a savings account, for instance, in a student’s name will count much more heavily against financial aid eligibility than if that same money were in the parents’ name, even if the family has that money earmarked for college.
Because of this, most 529 accounts are held by parents with students as beneficiaries. With this arrangement, the account is technically the parents’ asset. This means it counts less heavily toward the aid calculation.
Here’s where things get a little more complicated. What happens to financial aid if Grandma or Aunt Sue opens an account in her name with your child as beneficiary?
Nothing. At least, not the first year. Because the account isn’t an asset of the student or the parents, the FAFSA doesn’t count it at all. That is, it doesn’t count until the student takes a distribution from the account.
Distributions from a 529 not owned by the student or his/her parent count as income for the student. And, remember, 50 percent of the student’s income goes into the EFC. With the latest aid calculation changes, the funds will count two years from the year in which they’re distributed.
The best way to distribute money in these accounts is to wait until the student’s last two years of college, either graduate or undergraduate school, to distribute the money. At this point, the extra income boost won’t matter, since the student won’t need to count this income in their future FAFSAs.
Contributing to a 529 plan is as easy as writing a check or, with most of today’s plans, an online payment. Some plans let you set up an automatic monthly transfer from your checking account to the 529 plan.
Unlike with some retirement savings plans, contributions to a 529 aren’t tax-deductible, at least not on your federal taxes. You may be able to get a state tax credit based on your 529 contributions. The amount of the benefit varies from state to state. Most states only offer income tax benefits if you contribute to your state’s account. Some, though, offer the same benefits even if you contribute to an out-of-state plan.
Because the money going into a 529 isn’t tax-deductible, there are no limits on how much you can put into a 529. But you’ll want to be aware of gift taxes. In 2018, you can contribute up to $15,000 to one person before you trigger gift taxes. If you have concerns about potential gift taxes, check out this article from the IRS.
While any contribution to a 529 account is treated as a gift from the contributor to the beneficiary, typical families won’t run into an issue with gift taxes. Gift taxes don’t kick in until you contribute more than $15,000 a year to an individual, whether through a 529 or with a personal check.
If you happen to come into some money that you want to put into the account, or if grandparents or other family members want to give your child more than $15,000, there’s a way around the gift tax rule.
Basically, you can make one large lump sum donation to a 529 account but count it as up to five years’ worth of donations on your taxes. This can be a great option because it lets the large principal amount grow tax-free for longer. Check out this article for more information on this idea, known as superfunding.
The money in a 529 account can be used for any approved educational expenses. These include tuition and fees, room and board for students enrolled half time or more, books, necessary calculators and software, and services for special-needs students. The money can also be used for up to $10,000 per year in private K-12 tuition.
As of the 2009/10 school year, the IRS expanded approved expenses to include more technology. It used to be that students could use 529 funds for a computer or laptop only a class or college explicitly required one. Now, laptops, basic Internet service and some software programs are eligible expenses, for the most part.
Discretionary expenses, like gas or sorority/fraternity fees, aren’t included. However, you can use money in a 529 to pay for off-campus housing and food, as long as the total expenses aren’t more than the college’s estimated off-campus living expenses, which each college publishes annually.
There are a few keys to using the money in a 529 without being penalized:
- Money in a 529 can be used for educational expenses at any college, university, vocational school, or other post-secondary institution that is eligible to participate in a U.S. Department of Education sponsored student aid program.
- Withdrawals must be used to cover educational expenses in the same calendar year in which they’re withdrawn. If you find that you accidentally withdrew too much, you have 60 days to roll that money back into the 529 account or you’ll pay a 10 percent penalty and income taxes on the portion of the withdrawal made up of the account’s earnings. (Principal is never taxed or penalized because it comes from post-taxed earnings.)
- Certain tax credits, like the American Opportunity Tax Credit, may require you to lower your withdrawals because you’ll be getting some of that educational expense money back in your taxes. Talk to an adviser if you’re afraid of withdrawing too much from a 529.
- You can also withdraw money penalty-free in the amount of any scholarships a student has received, in the same calendar year in which the scholarship is paid out. This rule keeps account owners from paying a penalty for oversaving if a student happens to get lots of scholarships.
- If there’s money left over in a 529 account after a student is finished with school, you may want to designate a new beneficiary. You can withdraw the money left over, but you’ll pay taxes and penalties on any earnings left in the account.
As with any tax issues, it’s best to consult a tax professional before making any decisions.
Deciding when to withdraw money from a 529 account is tricky, especially if you have enough saved to cover more than just tuition. Many parents choose to withdraw the bulk of the funds when the tuition bill comes and then to make catch-up withdrawals later on.
For instance, if Johnny’s tuition bill for $10,000 comes in January, you might withdraw $15,000 from the account to cover the tuition bill, books, room and board, and other qualified expenses. If near the end of the year you find that you’ve actually paid $17,000 in expenses, withdraw the other $2,000 from the account before the end of the year.
Remember, if you don’t withdraw the money you spent in that calendar year before December 31, you can’t use 529 funds to pay for the expenses. You’ll have to eat those costs out of pocket, which means that you may end up with too much money in the 529 account by the time it’s all said and done.
Most parents don’t have to worry about this because most don’t have enough in the 529 to cover more than tuition, if they can even cover that. But if you do have questions about when to take 529 distributions, talk to a financial adviser about your options.
While 529s are the most typical sort of education savings account, they’re not the only option out there. So how do you know if a 529 is the right plan for your family? First, you need to understand what other options are available and then look at the pros and cons of various savings plans for college.
Other college savings plans include:
Prepaid Tuition Plans: These plans are a specific type of 529 plan, so they work similarly. However, with a prepaid tuition plan, you pre-purchase shares worth a semester of tuition at a state college. You buy a semester at today’s college price and use it later, even if the price of tuition has doubled.
Prepaid plans are tempting, especially as college tuition rates have been rising between 5 percent and 8 percent a year, on average. And besides buying prepaid tuition, you can earn interest on these plans, just like with a regular 529 account.
However, prepaid tuition plans may put you at a disadvantage if your child decides not to go to an in-state college or university, at which point you may not get as much out of the plan as you’d hoped. And it remains to be seen how these plans might treat potential private K-12 expenses, as well.
Coverdell Education Savings Account: A Coverdell ESA is similar to an IRA, but it’s specifically for educational expenses. The Coverdell account used to be the preferred option for parents who wanted to save for both K-12 and post-secondary education. But now the 529 will offer the flexibility, as well.
Also unlike a 529, the Coverdell comes with some limits. You can only use this account if your adjusted gross income is less than $110,000 (single parents) or $190,000 (married couple). Coverdell accounts can be more flexible investment-wise, but you must use them by the time your child turns 30 to avoid taxes and penalties.
Similar to a 529, the money in a Coverdell account grows tax-deferred, and you can withdraw it tax-free for educational expenses. As with the 529, states have different rules about income taxes on Coverdell accounts. But most states honor the federal rules and allow these accounts to grow income tax free. Also, the government treats the Coverdell like the 529 as far as financial aid goes, too. It’s a parental asset rather than a student asset.
UGMA Account: Another way to save for college is to open a Uniform Gifts to Minors Act account. This account lets you hold funds in your name as custodian for the benefit of a child.
UGMA accounts are helpful because they allow you to buy stocks, bonds, mutual funds and other contract-based investments for the benefit of a minor. Because minors can’t legally sign contracts, they can’t technically buy these things.
UGMA and the similar Uniform Transfers to Minors Act accounts are similar to trust funds, except they’re a lot simpler to set up. These accounts offer you the most flexibility investment-wise, and you can use them penalty-free on non-educational expenses.
Just keep in mind that these accounts don’t have the same tax benefits as 529s or Coverdells. And they also may impact student aid differently. Do your research to be sure you understand exactly how different types of UGMA/UTMA accounts impact future financial aid before you set one up.
Savings Bonds: Savings bonds have long been a popular way to save for college. Because they’re backed by the government, savings bonds typically carry very low risk, meaning you don’t have to worry about losing the money you invest for a child’s education.
The best way, perhaps, to save for college with a savings bond is through the Education Bond Program. This program makes the interest on certain savings bonds tax-free, as long as you redeem the bonds to pay for qualified higher education expenses. You can also roll bonds from this program into a 529 account.
So why is the 529 often best?
With all of these options, why is the 529 probably the most popular?
It offers a good blend of flexibility and benefits that most of these other options don’t offer. Also, you can easily blend a 529 plan with other education savings options for the best possible results.
The main benefit of a regular (not prepaid tuition) 529 is that your money grows tax-free. This makes a huge difference in the growth of the money you save, especially if you start saving very early.
By way of example, check out these calculations:
- Starting Investment Balance: $0
- Annual Contributions: $1,500
- Number of Years to Invest: 18
- Rate of Return: 8 percent
- Marginal Tax Bracket: 25 percent
- Future Account Value (fully taxable): $46,358
- Future Account Value (tax free): $56,175
The difference between a fully taxable account (UGMA) and a tax-free account (529/Coverdell) is nearly $10,000 over 18 years.
And that’s if you’re just investing $1,500 per year. Invest $3,000 per year, and the difference jumps to nearly $27,000 over 18 years: $110,357 vs. $137,286.
So, that tax-free growth makes a huge impact on your overall savings. And because most states have lowered their 529-related fees, these can be affordable investments, as well.
While the 529 offers lots of investment options, depending on which state’s plan you use, the Coverdell is more flexible and, thus, could get better returns. Many advisers suggest investing in a Coverdell first, if you’re eligible, until you reach the $2,000 limit. If you have more to invest than this, you can then put money into the 529.
The bottom line is that as long as you’re choosing the right 529 plan for your particular needs. And as long as you’re investing the money properly, it’s likely to be a good bet when it comes to saving for your child’s college education.
If you’ve hung in there for the full explanation of the 529, you’re probably interested in opening one for your child (or yourself), or at least checking out the options. And options there are.
Each state has at least one 529 plan, and many have multiple plans. Some states offer income tax write-offs for contributions, while others don’t. Some plans let you use a credit card to gain rewards, which are automatically added to your plan.
Choosing the best 529 isn’t easy, but it can be done. Here are some of the things you need to look for when comparing plans:
- Cost: Small fees really add up when you’re talking about 18 years’ worth of investments. Pay attention to the types of fees your 529 account charges to be sure you’re getting the best deal for your money.
- Tax Benefits: If your state offers tax write-offs for contributions to a 529, that state’s 529 may be the best option for your family. Some states’ write-offs are based on total contributions to that state’s 529 plans. Others offer a separate write-off for each individual plan. In the second situation, opening an account for each child and each parent can help maximize tax savings. And keep in mind that you can also use your state’s 529 to get the tax benefits but then invest in an out-of-state plan for more investing options, if you need to.
- Asset Classes: While most 529 plans offer fairly flexible investment options, you want to be sure you have a broad range of things to choose from so that you can diversify your account.
- Age-Based Options: If you’d like to put your account on auto-pilot, age-based investment options are nice. They start out more aggressive and risky when your child is very young and get progressively more conservative as college gets closer.
- Rewards Programs: While low costs and strong investments are more important than anything else, rewards programs can be great, too. Many states link their programs to UPromise, which lets you build up rewards for buying online through its site and/or using a particular credit card.
- Customer Service: Read reviews on 529 plans to be sure you’re going to get excellent customer service. This isn’t the type of thing you want to play around with, so customer service is essential.
Top 529s to Choose From
Still not sure where to start when shopping for a 529? Here are three of the top options (in no particular order) to choose from:
- Utah’s my529: Utah’s 529 program is known for its incredibly low fees, the highest are 0.395 percent per year, plus up to $3.95 per $1,000 invested annually. It offers Vanguard index-fund portfolios and typically performs well.
- Maryland College Investment Plan: Though the fees aren’t as low as Utah’s (0.83 percent at the highest), Maryland’s 529 offers a great mix of underlying mutual funds, which means you can choose from several high performing investment options.
- Michigan Educational Savings Program: Michigan’s investment options come with a variety of fees, many of which are lower than Utah’s. They also offer a guaranteed-principal option, so you know your money is at least somewhat safe.
Plans with tax benefits
Generally, it’s a good idea to go with your state’s plan if it offers tax deductions. Most of the time, high fees are offset by tax deductions, though you’ll still want to do some comparison. And, again, if you live in a state with tax benefits but high fees, you can invest enough with your state to get the tax benefits. Then kick the remaining investment over to another state’s plan.
The map below shows about how much a state tax deduction could be worth in various states. It’s based on information collected by SavingforCollege.com. As you can see, even in the highest-value states, the tax deduction isn’t worth a ton of money. So take that into consideration as you look at other benefits–including expenses–for various states’ plans.
For further reference, these states offer state income tax deductions for contributions to their 529 plans:
- Alabama: Alabama taxpayers are eligible for a state income tax deduction of up to $5,000 per individual ($10,000 if married filing jointly).
- Arizona: Tax deductions for Arizona taxpayers contributing to a 529 plan up to $4,000 for married tax filers and $2,000 for single.
- Arkansas: If you’re an Arkansas taxpayer, you can deduct up to $5,000 (up to $10,000 for married couples) of your GIFT Plan or iShares 529 Plan contributions from your Arkansas adjusted gross income.
- Colorado: Contributions to the program in a tax year are deductible from Colorado state income tax up to the extent they are included in your federal taxable income for that year, subject to recapture in subsequent years in which non-qualified withdrawals are made.
- Connecticut: The amount contributed by a Connecticut taxpayer to a CHET account during a tax year is deductible from Connecticut adjusted gross income in an amount not to exceed $5,000 for a single return or $10,000 for a joint return for that tax year. There is a five year carry forward rule on excess contributions.
- District of Columbia: Account owners who are District of Columbia taxpayers may deduct up to $4,000 in plan contributions each year on their DC tax return (up to $8,000 for married couples filing jointly if both taxpayers own an account and make contributions). If a DC resident exceeds the $4,000 contribution deduction in a calendar year, he or she may carry forward the excess for up to 5 years.
- Georgia: All Georgia taxpayers may now contribute and deduct up to $4,000 per year per beneficiary hen married filing jointly and up to $2,000 per year per beneficiary for all other filing statuses.
- Idaho: Idaho taxpayers qualify for a state tax deduction of up to $6,000 ($12,000 if married, filing jointly) for contributions to an IDeal account.
- Illinois: If you live in Illinois, you also get some added state tax benefits. Contributions to your Bright Start account are tax deductible—up to $10,000 per parent, per year ($20,000 if married and filing jointly).
- Indiana: Indiana residents can get an income tax credit of 20% of CollegeChoice 529 contributions, up to $1,000 per year.
- Iowa: For 2017, Iowa residents can deduct up to $3,239 in contributions per beneficiary from their adjusted gross income. (Deduction restrictions may change each year.)
- Kansas: If you live in Kansas and contribute to Kansas’s Learning Quest program, you could get an adjusted gross income deduction of up to $3,000 ($6,000 for married couples) per beneficiary, per year.
- Louisiana: Louisiana offers an interesting state-matching program in its START program. The state matches up to 14% of deposits each year. Also, Louisiana taxpayers can deduct up to $2,400 per account, per year from their taxable income.
- Maine: Maine residents can get a $200 matching grant or a $500 Alfond Grant when they open an account. They can also get a 50% matching grant of up to $300 per year on qualified contributions.
- Maryland: Maryland taxpayers can get up to $2,500 in adjusted gross income deductions per account each year.
- Massachusetts: The U.Fund Plan offers account owners the option to deduct up to $1,000 ($2,000 for married couples filing jointly) from their Massachusetts state taxes for contributions to the account.
- Michigan: If you live in Michigan and contribute to the MI Saves program, you could qualify for an income tax deduction of up to $10,000–for married couples filing jointly–or up to $5,000–for individuals filing single–per calendar year.
- Minnesota: Married taxpayers in Minnesota deduct contributions of up to $3,000 per year ($1,500 for single filers) from their state taxes. Taxpayers who don’t claim the deduction from federal taxable income for Minnesota income tax purposes may be eligible for a non-refundable tax credit of 50 percent of the account contributions made in a year.
- Mississippi: The Mississippi Affordable College Savings Program allows deductions of up to $10,000 for single filers or $20,000 for married couples filing jointly for total MACS contributions.
- Missouri: The Missouri MOST program allows Missouri taxpayers to deduct up to $8,000 ($16,000 for married couples filing jointly) in contributions per year from their state taxable income.
- Montana: Montana taxpayers can deduct up to $3,000 per taxpayer per year ($6,000 for married couples filing jointly) when they contribute to the Achieve Montana plan.
- Nebraska: Account owners can deduct up to $10,000 ($5,000 if married, filing separately) for contributions to their own NEST accounts. Parents acting as custodians on a child’s account can also take this deduction.
- New Mexico: New Mexico residents can deduct their plan contributions from their New Mexico state taxable income.
- New York: New York taxpayers who own NY Saves 529 accounts can deduct up to $5,000 ($10,000 for married couples filing jointly) of contributions per year.
- North Carolina: North Carolina taxpayers no longer get a tax deduction on contributions (as of 2014), although investment earnings are not taxed by the state if used for qualified educational expenses.
- North Dakota: North Dakota’s College SAVE program offers a tax deduction of up to $5,000 ($10,000 for married couples filing jointly) from their state taxable income.
- Ohio: Ohio residents who own Ohio CollegeAdvantage accounts can deduct up to $4,000 per beneficiary, per calendar year, with unlimited carry forward to future years.
- Oklahoma: If you pay taxes in Oklahoma, you could deduct up to $10,000 per calendar year ($20,000 for married couples filing jointly). Deductions can be carried forward for up to five years.
- Oregon: Oregon taxpayers can take up to $4,660 for married couples filing jointly, or $2,330 for singles in 2017.
- Pennsylvania: Taxpayers in Pennsylvania can deduct contributions of up to $14,000 per beneficiary per year (up to $28,000 for married couples filing jointly). Deduction cannot exceed taxable income.
- Rhode Island: Rhode Island taxpayers who contribute to the state’s CollegeBound program can get a state income tax deduction of up to $1,000 for married couples filing jointly, or $500 for individual filers.
- South Carolina: If you live in South Carolina, you could deduct whatever money you put into the state’s Future Scholar account, up to the maximum account balance of $426,000 per beneficiary. Also, money withdrawn from a Future Scholar account for qualified higher education expenses is exempt from South Carolina state income tax.
- Utah: The Utah Educational Savings Plan allows Utah taxpayers a 5% state income tax credit on contributions up to $1,920 per beneficiary (up to $3,840 for married couples filing jointly).
- Vermont: Vermont taxpayers who contribute to the Vermont Higher Education Investment Plan can take a non-refundable tax credit for 10% of the first $2,500 per beneficiary for a tax credit of up to $250 per beneficiary. Married couples filing jointly can get the credit on up to $5,000 per beneficiary.
- Virginia: Virginia taxpayers can deduct contributions of up to $4,000 per account per year, and deductions can carry forward indefinitely. Virginia taxpayers who are 70 or older can deduct the entire amount contributed to a Virginia529 account in one year.
- West Virginia: Contributors can take a state tax deduction for their contributions to the state’s SMART529 account.
- Wisconsin: If you pay taxes in Wisconsin, you can reduce your state taxable income by up to $3,140 per beneficiary per year ($1,570 for divorced parents with a beneficiary).
Keep in mind that you can have multiple 529 accounts for the same beneficiary. You could take full advantage of your state’s tax credit. Then you could contribute to a better-earning, lower-fees account from another state.
For instance, in Indiana, you can write off 20 percent of total contributions to 529 accounts (across all accounts, not per account) up to $1,000. If you’re a Hoosier, opening an Indiana 529 can be good idea. It falls in the middle as far as fees and investing options go,
Start by maxing out your tax credit by contributing $5,000 to one or multiple Indiana 529 accounts. Then, if you still want to contribute more, consider putting that money in a better account. Options might include one of the top five listed above.
The key is to compare your available options and to choose the option that works best for your family. If you’re completely stymied, you can talk with a financial adviser. Many of these plans have excellent websites that will tell you all you need to know about their fees, investment options, and more.
As noted above in this article, new federal laws mean you can now use 529 accounts for private K-12 tuition expenses–up to $10,000 per year. However, state laws are complicating matters quite a bit. Some states still need to adopt legislation that will allow residents to get state tax benefits if they use the accounts for K-12 expenses.
So there’s a chance that you could pay state taxes on 529 disbursements for K-12 tuition, even if you get the federal tax benefits. Some states, such as Indiana, are even considering putting penalties on K-12 withdrawals to recapture the tax benefit.
Bottom line: Talk to a tax professional who is familiar with the particular laws in your state before you decide to use a 529 for elementary or secondary expenses.