A 529 plan is a tax-advantaged educational savings plan operated by an educational or state institution. 529 plans were created by Congress in 1996, and “529” stems from their required compliance with section 529 of the Internal Revenue Code. They are legally known as “qualified education programs.”
There are two types of 529 plans: the traditional and more well-known type, “college savings” or simply “traditional” 529 plans, and “prepaid tuition” 529 plans. In this article we’ll be discussing the former variety—to learn more about prepaid plans, see Prepaid 529 Plans.
College Savings 529 Plan Definition
A college savings plan is a tax-advantaged investment vehicle designed to encourage saving toward higher education. They work similar to individual retirement accounts (IRAs) on that you (the “college saver” or “account holder”) will be investing your contributions within your pick of stock, bond, and/or money market mutual funds. Likewise, they are subject to market risk and thus may not generate any profit or even decline in value. Unlike a select few prepaid 529 plans, they also do not have state backing or guaranteed results.
Types of College Savings Plans
529 college savings plan portfolios can be static or age-based.
Like a target-date fund, age-based portfolios automatically shift toward more conservative investments as the beneficiary’s window of time before college age narrows.
Static portfolios have a fixed asset allocation, and you may choose where each of your portfolio’s investments lie on the conservative-aggressive spectrum based on your risk tolerance.
What College Savings Plans Cover
Distributions from college savings plans can be put toward tuition and mandatory fees, room and board, and even required books, computers, software, and even Internet access.
College Savings Plans’ Tax Implications
529 college savings plans are lauded for their tax benefits, which are similar to those of Roth IRAs. Contributions grow tax deferred and can be withdrawn federal-tax, and often state-tax, free so long as they are used for qualified educational expenses. That being said, federal contributions are not tax deductible, although you may receive a deduction for state income taxes.
If earnings are not used for qualified educational expenses, however, they are subject to regular income tax plus a 10% federal tax penalty (as is the case for many types of retirement accounts).
A word of caution: If the amount of 529 plan savings distributed is greater than the beneficiary’s qualified education expenses, taxes may be owed on the difference. Distributions and the expenses they are intended for must be within the same calendar year to qualify.
States follow the federal treatment of 529 college savings plan taxation, and some also allow a state income tax deduction and even matching contributions as incentives for their residents to choose their home state’s 529 plan, given that state residency is not a limiting factor.
Specifically, 34 states and the District of Columbia offer a full or partial income tax deduction on 529 plan contributions. Among those remaining are the seven states that simply do not charge a state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming; and nine states that don’t offer a deduction: California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, North Carolina and Tennessee.
Additionally, some states have a loophole that allows a current college year’s costs to be contributed to a college savings 529 plan and withdrawn as soon as a day later, making the account holder eligible for an income tax deduction as long as the funds are used for qualified education expenses. This is due to their lack of a waiting period on withdrawal of funds, which other states impose a one-year waiting period for.
In choosing where to open your 529 plan, weigh the potential savings from state income tax-deductible 529 plans and any other perks that may be offered against the potential after-fee returns of out-of-state 529 plans; it could be that out-of-state 529 plans are still a better option due to lower fees. That is typically the case for longer investment horizons, but if the beneficiary will be enrolling soon, the deduction likely trumps the lower fees due to the shorter amortization period.
Enrolling in a College Savings Plan
Anyone 18 years of age or older who holds U.S. citizenship or resident alien status may enroll in a 529 college savings plan for another person or even for themselves. A beneficiary may also have multiple accounts opened in their name by different individuals.
College savings plans are available in all states as well as the District of Columbia, and you aren’t limited in choice to those in your own state.
College savings plan enrollment is open year-round. However, investment options may only be chosen once per year.
You may roll over money from one 529 plan to another or change beneficiaries within a 60-day time frame. However, beneficiaries’ accounts can only be rolled over once per year.
College Savings Plan Annual Contribution Limits
The 2017 maximum contribution one can make per beneficiary without incurring the gift tax (that is, the gift tax exclusion) is $14,000, and a special provision applying to 529 plans permits up to five years’ worth of contributions to be gifted in one front-end lump sum, for a total of $70,000.
A married couple can contribute double; up to 28,000, or if they opt for the five-year lump sum, $140,000.
College Savings Plan Contributions’ Impact on Financial Aid
Expected family contribution (EFC) is a measure of how much a dependent student and their family can put toward their child’s post-secondary education and is a prime determinant of eligibility for financial aid, such as Pell Grants and work-study programs. Education savings accounts such as 529 plans are factored into its calculation, but relatively minimally. If a 529 plan is owned by the dependent student (as a custodial account, or one that a parent controls for a minor) or their custodial parent (includes a stepparent if married to the biological custodial parent), it is reported as a parental asset of the parent on the Free Application for Federal Student Aid (FAFSA). Parental assets are assessed at a maximum rate of 5.64%. In other words, up to $56.40 of every $1,000 held in 529 plans may be included in the EFC. This is fortunate by comparison to alternatives; the federal aid formula counts between 22% and 47% of parental income in the EFC, and student assets are assessed at 20%. Further, if a parent has a 529 plan for more than one dependent child, they must report it as part of their net worth investments on the FAFSA, even if the others are not currently filling out a FAFSA.
If the plan is owned by anyone besides the student or their custodial parent, it is not reported as an asset. Instead, when the nonparent withdraws the funds to pay for the beneficiary’s college expenses, 50% of the amount is counted as student income on the FAFSA for two years hence (starting with the 2017-2018 school year), as Vanguard explains. Thus, if a grandparent withdraws $10,000 from their 529 plan account and provides it to a college freshman, $5,000 of it will count towards determining their available assets with regard to financial aid eligibility on their FAFSA submitted during their junior year.