If you’re a parent or a future college student wondering how you’ll ever pay for college, the tax-advantaged 529 college savings plan was designed to encourage saving for future education expenses–even for elementary and secondary students. I’m working with Pelican to help educate people on how to save for college, especially with support from your family and friends.
By saving in advance and allocating 529 funds to various investment options, you might not need to take out any student loans to attend college. That can save a considerable amount of interest over the life of a loan.
Here are ten ways a 529 plan makes going to private school, vocational school, or an accredited college or university (in the U.S. or abroad) more affordable.
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1. Having tax-free growth.
A 529 college savings plan allows you to name and save for a future student or beneficiary, such as a child or yourself. You contribute and choose investments from a menu similar to a retirement account.
Unlike a traditional retirement account, you don’t receive a tax break for 529 contributions; however, your investment growth–such as interest, dividends, and capital gains–is tax-free. That allows your balance to grow faster than it could in a taxable brokerage account.
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2. Making tax-free withdrawals.
In addition to tax-free growth, your withdrawals from a 529 plan are not taxed at the federal (and often state) level if you spend them on qualified education expenses, which I’ll cover. That means you don’t lose part of your account to taxes when you’re ready to spend it on qualified education expenses for the beneficiary.
However, a significant downside of a 529 plan is that if you spend it on anything other than qualified education expenses, your account earnings are subject to income tax and a 10% penalty. There are exceptions, such as when the beneficiary receives a scholarship, veteran’s educational assistance, becomes disabled, or dies.
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3. Claiming state tax deductions or credits.
Most states offer at least one 529 plan; however, the fees and benefits vary, such as the maximum contribution limit and investment options. You typically don’t have to be a state resident to participate in its plan. For instance, you could live in New York, participate in a Florida 529 plan, and use the money to pay for a school in California.
However, some states that collect income tax offer a tax deduction or credit on your state tax return for residents who choose an in-state 529 plan. That could add up to significant savings, depending on where you live. Therefore, the tax benefits of a 529 planopens pdf file vary depending on your home state, how much account growth you receive, and which plan you choose.
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4. Having high contribution limits.
Most 529 plans have high contribution limits, such as more than $200,000 or $300,000 per beneficiary. That allows you to save as little or as much as you need for your or a child’s education expenses from kindergarten through graduate school.
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5. Shielding more income from financial aid calculations.
While a parent-owned 529 plan is a component of federal financial aid calculations, it’s a relatively small amount compared to other accounts. For instance, savings owned by a future student, such as in a UTMA/UGMA custodial account or a Roth IRA, count more toward the Expected Family Contribution for financial aid.
A 529 beneficiary typically isn’t the account owner. That makes having a 529 plan an advantage for families and students who need financial aid to supplement savings because it won’t reduce their potential aid as much as other accounts.
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6. Receiving gifts from others.
A 529 plan offers unique gifting features that make the beneficiary more likely to have enough education funds. Platforms like Pelican make it easy to create your 529 and encourage family members and friends to contribute to a student’s plan.
For instance, a child’s grandparents could add funds regularly over many years or make a lump sum contribution, which can be advantageous for their estate planning purposes.
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7. Getting account flexibility.
Everyone can use a 529 plan because there are no restrictions on annual income. Plus, unlike some education savings accounts, there’s no time limit or beneficiary age when you have to spend it. The funds can be used later if a child doesn’t go to college immediately after high school.
In addition, if a child decides not to go to college or doesn’t need all the funds, you can transfer it to a new beneficiary in your family with no taxes or penalty.
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8. Transferring unused funds to a Roth IRA.
If you have unused 529 funds but no different beneficiary can use them, cashing out is an option. However, as previously mentioned, you’ll owe tax on the earnings portion, plus a 10% penalty.
However, the 529 must be open for at least 15 years, and the lifetime rollover limit is $35,000 per beneficiary. Plus, any 529 contributions (and their earnings) made within the past five years can’t get transferred to a Roth IRA.
Note that the rollover Roth IRA must be in the beneficiary’s name, not the 529 plan. That means your child must have some amount of earned income to qualify for a Roth IRA in the first place.
For 2023, you can contribute up to $6,500 to a Roth IRA if you’re under 50 and have that much earned income. So, this tax-free rollover benefit only applies to working older children–but may give them an excellent head start on retirement savings.
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9. Using it for younger students.
I mentioned that 529 funds can also be used for younger students, a relatively new benefit in the Tax Cuts and Jobs Act of 2017. It expanded qualified expenses to include tuition for kindergarten through high school for up to $10,000 per student annually. You can spend it on public, private, or religious school expenses for a child whether they attend college or not.
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10. Having a range of qualified expenses.
Qualified education expenses for your 529 savings include tuition, room and board, books, supplies, required equipment, special needs services, and computer technology. Plus, you can include up to $10,000 for student loan repayments and costs related to registered apprenticeship programs.
However, 529 funds can’t be used to pay for a student’s education loan interest, extracurricular activities (like sports or clubs), transportation, health insurance, or cell phone. If you’re unsure if a fee is 529-qualified, check with your plan provider.
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How to track your 529 plan distributions
As you spend 529 funds, keep physical or digital receipts to prove your distributions are equal to or less than the amount of your qualified educational expenses. Your 529 plan provider will send you and the IRS a copy of Form 1099-Qopens pdf file showing your annual distributions. As I mentioned, you typically also must pay an additional 10% penalty on the earnings portion if your distributions exceed your qualified education expenses.
You might pay your qualified expenses first and reimburse yourself from the 529. Be sure your 529 withdrawals and payments occur in the same calendar year; otherwise, a distribution may be considered non-qualified.
Another way to manage qualified expenses is to move money from a 529 to your bank account or authorize a 529 provider to make a payment. Getting funds upfront may be best when you have large bills, such as college tuition, and don’t have enough to cover it in your bank account before getting reimbursed.
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How to boost 529 plan contributions
Once you open a 529 plan, set a goal to make regular contributions. Whether you contribute $10 or $1,000 a month, the sooner you get started, the easier it will be for you and your family to pay for college.
Why not invite other people to make 529 gifts and contribute for special events, such as a future student’s birthday or as a holiday gift?
Check out PelicanInvests.com for 529 plan resources and great ways to share your savings goals, encourage family participation, and hopefully make paying for college much easier.
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