Parenting is a bit of a strange conjunction of incongruities. As soon as you bring your child home from the hospital, you’re probably already starting to worry about how to save for their college expenses. And with the costs of college rising faster than inflation, you’re not wrong to start thinking about college while your child is still in diapers. In this article, we will talk about 529 plans – what they are, how to use them and why this can be one of the best vehicles for saving for college expenses.
What is a 529 plan?
A 529 College Savings Plan (typically referred to as just a 529 Plan) is a vehicle that can be used primarily for parents and guardians to save for the higher education expenses of their dependents. It is named after Section 529 of the tax code and was first introduced in the 1990s. A 529 plan is a shorthand way to refer to one of several different types of accounts for post-secondary education expenses.
Tax advantages of a 529 plan
A 529 plan occupies the same lane as a Roth IRA can for individual retirement savings. That is to say that you contribute after-tax income to your 529 plan. Then, the money in your 529 account can be invested how you choose. When you are ready to use the money, you can withdraw the principal and any earnings tax-free as long as you use it for qualified educational expenses.
There are many different 529 plans
529 plans were first introduced back in the 1990s by the individual states rather than by the federal government. Then as part of the Small Business Job Protection Act of 1996 and the Taxpayer Relief Act of 1997, the framework of 529 plans was codified into the tax code.
Still, most 529 plans are administered by individual states. While most state 529 plans allow out-of-state investors, there are often state tax advantages to using the 529 plan of the state you live in. As one example, Ohio allows up to $4,000 of contributions per beneficiary to be deducted from your Ohio taxable income. One thing to watch out for with the different 529 plans is to compare the different fees associated with the account. If your state’s 529 plan comes with higher than average fees or fund expenses, it may make sense to participate in another state’s plan, even if you miss out on state tax breaks.
While it may seem a bit overwhelming to have several different choices, it’s important to not let that stop you from creating a 529 plan. You’ll definitely come out way ahead investing in a 529 plan as compared to simply keeping that money in a low-interest savings account.
Who can contribute (and how much!) to a 529 plan?
There is no set limit for how much you can contribute to a 529 plan, though some individual plans have their own limits for annual contributions. One thing to be aware of if you are contributing to a 529 plan for a beneficiary that is not your dependent (such as a grandchild) is that there are limits to how much you can contribute without incurring a gift tax. Currently, you (and your spouse) can give $15,000 per year per beneficiary without being subject to the gift tax.
What you can use a 529 plan for?
You as the account owner can take out money from your 529 plan at any time, tax-free, as long as you use it for qualified distributions. Eligible expenses include any expenses related to undergraduate or graduate education, including tuition, books, computers, and even room and board. As of January 2018, you can also use 529 plans to pay for their childrens’ tuition at private elementary and high schools.
You can also change the beneficiary of a 529 plan at any time. This can be useful if you have several children. You can make contributions for each of your children (perhaps spreading them out to take advantage of limitations on tax breaks). Then, you can combine or assign the beneficiary of the account to the child that currently has the educational expenses. This strategy can also work if you have a child who decides not to go to college. Instead of withdrawing the money and paying a 10% penalty, you can simply change the beneficiary of the 529 account.
Another advantage of having a 529 plan is that the account (and money) are in your name, meaning that you have complete control of the account. This prevents your child from using or accessing the money without your consent. Additionally, money in your name is treated more preferentially than money in your student’s name when determining your expected family contribution (EFC) for financial aid.
Hopefully, this information will help you as you strive to make the best plan to pay for college and other higher-education expenses.