Let’s be honest, college in the United States is expensive. When you have children, the first thing on your mind likely is not whether or not they will obtain a college degree – it is more likely about keeping your child safe and healthy. But if you start planning early enough, a 529 plan can cover your child’s future education including tuition, fees, books, and more.
The sooner you begin saving, the larger you can boost the balance available for your child when they begin their college journey.
How Does a 529 Savings Plan Work?
A 529 savings plan is a state-sponsored plan designed to save money for your child(ren)’s future education. They are a tax-advantaged savings plan and are run by all states and the District of Columbia.
When you open a 529 savings plan, you will be the account owner and the beneficiary will be your child (or the student who will receive the funds for college). As the owner, you control the investments within the savings plan.
While most people assume that a 529 savings plan is for future college education only. In 2021 most savings plans now allow the funds to be utilized for K-12 private and public education, religious school tuition, and apprenticeship programs.
Who Can Open the 529 Savings Plan?
There is no set person who can open a 529 savings plan. A parent, grandparent, friend, relative, or even the student can open a 529 savings plan. As long as the person setting up the account has the beneficiary’s social security number, they can set up an account on the student’s behalf.
While there are no income eligibility requirements to set up a 529 plan, the IRS does maintain that contributions cannot be more than necessary to fund the educational expenses of the student. Because of this, many states cap the total contributions between $350,000 to $500,000.
Who Can Be the Beneficiary?
When opening a 529 plan, anyone can be the beneficiary. The purpose of a 529 plan is to ensure the beneficiary can pay for their future education without the burden of financial aid.
Does Each Child Need a Separate Account?
If you are a parent of more than one child, you do not necessarily need to set up multiple 529 plans for each child. In fact, with the benefits of compound interest, many parents choose to only set up one plan and change the beneficiary when the time is right.
In the event that one child does not attend college, or you want to continue reaping the benefits of compound interest, you can easily change the beneficiary on the 529 plan twice a year without penalty.
Can Relatives, Grandparents, or Friends Help?
Relatives, grandparents, friends, and any third-party can make contributions to a 529 plan, even if they do not own the account. They can make the gift contribution to the account through check or online payment, depending upon the specifics of your plan details.
Advantages of 529 Savings Plan
When looking at different investment vehicles to fund your child(ren)’s education, a 529 savings plan is full of appeal.
Tax Advantages
The money that you invest in a 529-savings plan will grow on a tax-deferred basis. When the student utilizes the distributions for qualified educational expenses, they will be completely tax-free. Qualified education expenses include tuition, fees, books, supplies including computers, room and board, and now even K-12 tuition.
Gift and Estate Planning Benefits
You can contribute funds to a 529 account that are taken from your taxable estate, then passed free of federal gift taxes to the savings plan up to the annual limit of $15,000 for an individual or $30,000 per couple. The better news is that you can make five-years’ worth of these tax-free gifts all within one year, but you can only utilize these tax savings every five years.
This means you can contribute up to $75,000 as an individual, or $150,000 per couple, to a beneficiary’s 529 savings plan while minimizing the tax obligations to your estate.
Withdrawals and Flexibility
When you invest in a 529 savings plan, they come with a lot of flexibility. In fact, you can withdraw funds at any time from the plan, for any reason. If they are used for qualified educational expenses, they will be tax-free. However, if you choose to withdraw funds that are not for qualified educational expenses there will be a 10% fee, federal tax penalty, and possibly a state and/or local tax penalty as well.
High Contribution Limits
Unlike other savings and investment vehicles, like a Roth IRA, a 529 savings plan does not have any annual contribution limits. As mentioned above, the IRS does regulate contributions, stating they cannot be more than necessary for the educational expenses of your student.
The state may cap the contributions somewhere between $350,000 to $500,000. The better news is you do not have to select a 529 savings plan from the state you reside, so you can choose the savings plan option that fits best for your child’s educational needs.
Disadvantages of 529 Savings Plan
With so many advantages to a 529 savings plan, it might seem like the ideal option for your child(ren)’s future educational expenses. But before picking the plan that is right for you, you should consider the disadvantages of the plans to make sure you like it as an investment strategy.
Fees & Penalties
As long as the funds are utilized for qualified educational expenses, they will not be subject to fees or taxes. However, if you make non-qualified distributions, they will be subject to a 10% penalty on the earnings, as well as to income tax.
There are also management fees that come with 529 savings plans. If you select a plan with a higher management fee, your returns for the beneficiary might not be as high as anticipated.
Limited Investment Choices
Money invested into a 529 account does not have a full range of investment choices. Most 529 savings plans typically invest in mutual funds and provide investors with a “menu” of options to choose from. Others may offer individual stocks or exchange-traded funds, but your options are limited.
Financial Aid
When your child is ready to utilize the funds invested for their education, it might impact their access to student aid. Your family’s financial picture is considered when your child completes their application for student aid (FAFSA), and the 529 savings might increase the Expected Family Contribution (EFC).
Based on the EFC, the Department of Education estimates how much one can afford when paying for their college education. If the student has a higher EFS, they could receive fewer federal grants, subsidized loans, and work-study opportunities.
What Happens If the Beneficiary Doesn’t Want to Go to College?
If you have been saving for a 529 plan for years or are considering investing in one for your child(ren), but you are concerned they will not attend college, have no worries. If the beneficiary decides that they do not want to attend college, there are three ways you can ensure the funds are used.
Other Education Besides College
Your student’s 529 savings plan does not have to be used for traditional college. Instead, it can be used for vocational and trade schools. It can also be utilized for programs that are abroad. Any post-secondary training is considered a qualified education expense.
Change Beneficiaries
If your child decides not to attend college, you can change the beneficiary two times annually. You can transfer the account to another child, niece, nephew, other relative, or even yourself.
Use Money For Non-Qualified Expenses
There is always the option to utilize the savings for things not associated with secondary education. However, using the funds for non-qualified expenses does come with the 10% penalty fee on the earnings, along with income tax obligations.
How To Choose a 529 Plan
Before investing in a 529 plan, consider the criteria that you would like out of a plan. 529 savings plans vary based on state, performance, and cost.
Look at the options available and assess the annual return on the investment, costs associated with the plan, tax benefits, investment options, and maximum contributions. After you have compared the different options, you can determine which 529 plan makes the most sense for your family.
Saving For College While Taking Advantage of Compound Interest
Being smart about college savings means that you are making your child(ren)’s education a priority. Not all 529 plans will fit your family’s needs, and that is why you should consider turning to your financial advisor for guidance. They can help you assess the goals you have for your child(ren)’s future education and help select a plan that aligns with these goals.