Ready to start saving for your children’s college? There are plenty of ways to get started, such as investing in mutual funds, a CD, a Coverdell ESA, a savings bond and so on, but a 529 savings plan is by far the most popular, widely used choice.
Similar to these other savings options, a 529 college fund is something you invest in early on to reap the full benefits. So what are the benefits, anyway, and what is a 529 college savings plan?
A 529 plan is an education funding account you can set up for yourself, your child or even your niece and nephew. It’s a tax-advantaged investment account that was specifically created for certain education expenses, such as tuition, and are state-run. They come in two groups—a prepaid tuition plan and a savings plan, which we’ll review later—and a nice variety of tax benefits that you and your family can take full advantage of.
In this article, we’ll cover everything you need to know about 529 plans, from the different types, investment options, the tax advantages and more so you can start saving today.
Prepaid Tuition Plans and Education Savings Plans
There are two types of 529 education plans you can choose from: a prepaid tuition plan and an education savings plan. While both plans offer tax benefits intended for saving for your child’s higher education, there are a few key differences. Let’s take a look at how each option works.
Prepaid Tuition Plan
A prepaid tuition plan allows you to pay for your child’s future tuition by purchase college credits at today’s price, as long as it’s with a participating school. With college tuition consistently rising year after year, putting money into a prepaid tuition plan is a great way to save money while also enjoying the tax benefits of a 529 plan. This plan type gives parents peace of mind that their savings goals won’t change based on the prices of schooling going up.
Additionally, the United States Securities and Exchange Commission guarantee that prepaid tuition plans are backed by the state.
One thing to remember when opting for a prepaid tuition plan is that you or your beneficiary must be a resident of the state that is sponsoring the plan. Additionally, this 529 plan type comes with a limited enrollment period.
Education Savings Plan
A 529 education savings plan, on the other hand, allows your contributions to be placed in investment funds, such as stocks and mutual funds. While this option may be riskier in the beginning where the performance of the investments can go up or down depending on the market, most of these plans will select more stable and less risky investments as your child gets closer to freshman year, when they’ll be ready for the funds. You can determine what your investment options are once per year.
Unlike a prepaid tuition plan, education savings plans are not guaranteed by the state nor are they federally insured. Additionally, you can enroll at any time throughout the year with this plan type.
529 Plan Fees
When it comes to fees, this depends largely on how much you invest as well as the organization running the plan you choose. Generally, fees will include a portion of the annual account amount plus maintenance fees.
Additionally, if you select an advisor-sold plan, you’ll need to compensate them for their service in managing the 529 college savings account.
Choose a 529 Plan Investment Option
As mentioned in the previous section, a 529 education savings plan allows you to select what investments you’re contributing to. How it works is you’ll be presented with investment options at the time of opening your 529 account. Once you make your selection, the value of these investments will rise and fall depending on their performance.
So how do you know which investment option to choose? Let’s take a look at the two primary investment options—age-based portfolios and static portfolios.
With this investment type, the allocation of assets will automatically change as the child ages over the duration of the 529 plan and will move towards less risky investments.
This option is ideal for parents who don’t want to think about managing their investments and those who just want to pick an investment and forget about it. One thing to keep in mind with age-based portfolios is how aggressive or conservative it is. This can vary depending on the 529 plan you choose. Every plan manager will have their own defined level of risk for a given age.
Unlike an age-based portfolio, the asset allocation of a static portfolio will remain the same over the duration of the plan unless you choose to reallocate the assets to other portfolios. In short, this investment type is best for those who are more experienced with investments and who may have a specific objective when investing.
Static portfolios can be broken down further into two types: target risk portfolios and individual portfolios. Target risk investments will adjust regularly to meet their target. They typically have names like “Income Portfolio” or “Aggressive Growth Portfolio.”
Individual portfolios will mirror their underlying investments, which use open-ended or exchange-traded mutual funds. This is a great option if you want to really customize your investments.
What Happens if the Beneficiary Doesn’t Go to College?
Some parents have reservations about opening a 529 college savings account simply because they aren’t sure if their child will even go to college. What happens then?
When it comes to your 529 plan, there’s no need to worry about whether or not your child goes to college. You can still use the money for non-education expenses, but you’ll be subject to a 10% penalty as well as taxes on earnings. But the money won’t be lost.
There are a few additional options available to you that won’t incur a penalty or your earnings being taxed. One option is to change the beneficiary on the account, which you can do at any time. The only caveat is that it can only be changed to another family member of the beneficiary. You can make this change once per year without incurring any fees. Additionally, you can always change it back if your child decides to attend college after all.
Another option is to use the 529 plan funds for K-12 education, where you can use up to $10,000 per year. Many parents don’t realize that 529 plans can be used not only for college, but K-12 and postsecondary education, which includes trade school, community college, and certificate programs.
If your child has a disability which you believe will prevent them from attending college, you can convert your 529 plan to another type of tax-benefited account known as the Achieving a Better Life Experience (ABLE) plan which can be used for qualifying expenses.
Finally, there are special instances where the 10% penalty on non-educational expenses can be waived, but they’ll still be subject to income taxes on the earnings. These extenuating circumstances include death, disability, military attendance, and scholarships.
Who Can Open a 529 Plan?
Pretty much anyone can open a 529 college education fund, such as parents and grandparents. For parents, this would be either the mother or father of the beneficiary. Parents benefit most by opening a 529 plan early while their future college grad is still a young child or even baby so the account will have plenty of time to grow.
You can even open a 529 education fund for yourself as long as you’re 18 years or older. This could benefit those looking to change careers or go to graduate school. While you won’t have much time to build up your savings, you can still be eligible to claim a deduction on your state taxes for your contributions.
Who Can Be a Beneficiary
A 529 plan beneficiary must be a family member, which, according to the IRS, includes blood relatives as well as relatives by adoption or marriage.
To be more specific, a family beneficiary includes:
- Child, foster child, adopted child, or stepchild
- Sibling or step-sibling
- Father, mother, step-father, step-mother
- Son-in-law or daughter-in-law
- Father-in-law or mother-in-law
- Aunt, uncle, or their spouse
- Niece, nephew, or their spouse
- First cousin or their spouse
Tax Advantages (qualified education expenses)
While a 529 savings plan offers some excellent benefits, such as its flexibility and minimal impact on eligibility of financial aid, the main benefit is the tax advantages.
529 plans offer tax-free growth and tax-free withdrawals, as long as they’re used for qualified education expenses. This allows you to save money by making contributions without the need to pay taxes on your earnings. Additionally, most state-run plans will offer their residents a partial or full deduction or tax credit for contributions made to a 529 plan.
Does a 529 Plan Impact Financial Aid Eligibility?
How much financial aid a student is eligible to receive depends largely on their Expected Family Contribution (EFC), which essentially assesses the financial fortitude of a family by considering the student’s and parent’s assets and income.
Ultimately, the impact a college savings plan can have on a student’s financial aid depends on the type of plan and the plan owner. If the account is owned by a parent or dependent student—generally an undergrad still living with Mom and Dad—then a 529 plan will actually have a better impact on financial aid eligibility than other college savings account types.
In short, money saved in a 529 plan owned by the student or parent has the least financial aid eligibility reduction than a student’s custodial bank or brokerage account, a grandparent-owned 529 account, or a Roth IRA account.
What Expenses are Qualified and Non-Qualified?
The tax perks for a 529 college fund are only available for qualified education expenses. This includes the following:
- Tuition and fees (limited to $10,000 each year for K-12 education)
- Books and supplies (college only)
- Internet access and computers (college only)
- Room and board (college only)
- Special needs equipment (college only)
A few commonly confused non-qualified expenses include:
- Transportation and travel costs
- Health insurance
- College testing and application fees
- Fees associated with extracurricular activities
- Student loans
Contributions to a 529 Plan?
When it comes to contributions made to a 529 savings account, there are a few things to keep in mind. The first is the annual contribution limit. Unlike Roth IRA and 401K accounts, the IRS doesn’t specify a limit for 529 plans. Each state runs its own 529 plan and they determine the rules and maximum contribution limits—so the amount will vary depending on where you get your plan.
You’ll also want to consider the fact that contributions made to a 529 account are counted as gifts for tax purposes. As of 2019, gifts amounting up to $15,000 per individual will qualify for the annual gift tax exclusion. The excess amount will have to be reported on Form 709 when filing your taxes.
You can contribute up to $75,000 in a 529 account if it’s treated as if it were spread out over a five year period. A 5-year election needs to be reported on a Form 709 for each of these five years. So if you deposit $50,000 into a 529 plan, it will be applied as only $10,000 each year, resulting in a $5,000 unused annual exclusion each year.
Can Grandparents and Family Members Contribute?
What’s great about having a 529 education plan is that it’s contributions aren’t limited to the plan owners. Friends, grandparents, and other family members can make contributions too. A contribution, no matter how big or small, can make an excellent holiday or birthday gift and will have a longer-lasting impact on your child’s future.
By opening a 529 college savings account with U-Nest, an easy-to-use mobile app designed for establishing tax-free college savings, you can sit back and watch your money grow from contributions made by you and loved ones. It’s easy, efficient, and best of all, it takes less than five minutes to open your account. If you’re a grandparent, we recommend investing in a 529 Plan, one that gives you peace of mind for you grandchildren’s future.
There are plenty of ways to start saving for your child’s future, but the key is to start today. A 529 plan offers the best tax advantages for contributions, choosing investment options can be simpler than you think, the money in the account won’t be lost if your child doesn’t attend college, and it’s easy to get started.
You can open an account today by downloading the U-Nest 529 Plan app to start saving for your child’s financial future.