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17 Great Reasons to Save for College with a 529 Plan (and 5 Reasons to Be Cautious)

Congress strongly believes in the benefits of education, so much so that it has loaded the federal tax code with numerous tax breaks for it.  Nowhere is that belief more evident than with Section 529 savings plans, by far the most powerful and flexible savings vehicle available for education. 

What Is a 529 Plan?

A 529 plan is a college savings plan with major tax advantages. Contributions to a 529 plan are not tax-deductible on your federal income tax return, but the earnings on those contributions grow tax-deferred and are tax-free when withdrawn, provided the funds are used for “qualified education expenses.” 

The catch?  If 529 plan earnings are withdrawn and not used for education expenses, they’re subject not only to income tax but also to a 10 percent penalty tax.

529 plans come in two basic flavors:  (1) prepaid tuition plans, and (2) savings plans. All 50 states and the District of Columbia sponsor at least one type of plan.  This article discusses 529 savings plans, and the many compelling reasons to take advantage of them.  We also look at a few reasons to consider them carefully.

The 17 Great Reasons

  1. Plan contributions grow tax deferred.  Just as with an IRA or 401(k) account, the money in your 529 plan grows tax-deferred, which maximizes the account’s potential earnings and value when it comes time to pay the tuition bill.

  2. Plan earnings can be withdrawn tax-free.  Provided the funds are used for qualified education expenses, distributions of earnings from 529 plans are tax-free. Plan withdrawals used for education are also tax-free in nearly all states.

  3. You can use the funds for virtually all education expenses.  These include tuition, fees, books, supplies, equipment, and special needs expenses.  In addition, 529 plan funds can pay for room and board, so long as the student is enrolled at least half-time.  529 funds can even be used for computer hardware, educational software, and internet access.

  4. Contribution limits are very generous.  Although the IRS states that contributions “can’t be more than the amount necessary to provide for the qualified education expenses of the beneficiary,” 529 plan contribution limits range from $235,000 to over $500,000, depending on the state.  

  5. There are no income restrictions on 529 plans.  Unlike most other educational tax benefits, 529 plans have no income restrictions, either on the person contributing or on the beneficiary.

  6. Anyone can set up a 529 plan and name anyone as the beneficiary.  There are no age limits.  Parents, grandparents, friends, and relatives can set up plans for any beneficiary, whether friend or family.  You can even name yourself as the beneficiary.

  7. There’s no limit to the number of plans you can set up.  Each 529 plan has one designated beneficiary.  If you have more than one child or grandchild, for example, you can set up a plan for each of them.

  8. The 529 plan owner stays in control of the money.  Whoever sets up the 529 plan is the custodian and controls the funds until they’re withdrawn.  By contrast, with a UTMA or UGMA custodial account, the child gains control of the money at the state’s age of majority (generally 18), and can use the funds for any purpose.

  9. You can change the plan beneficiary at any time.  While each 529 plan has one designated beneficiary, you can change the beneficiary at any time, with no tax consequences, provided the new beneficiary is a member of the original beneficiary’s family.  (See reason 10 regarding the generous definition of “family.”)

  10. You can roll over funds from one 529 plan to another.  Rollovers from one 529 plan to another are tax-free, whether it’s for the same beneficiary or for a member of the beneficiary’s family.  For example, you can roll unused funds from one child’s 529 plan into the 529 plan for another of your children, with no tax consequences.

    Note that, for purposes of rollovers or transfers from one beneficiary to another, the term “beneficiary’s family” is very broadly defined, including the beneficiary’s spouse, children, siblings, parents or grandparents, uncles and aunts, nieces and nephews, in-laws, and the spouses of any of the foregoing.  Even first cousins of the beneficiary (but not their spouses) qualify.

  11. You aren’t restricted to your own state’s plan.  You can invest the money in any state’s plan, although state tax benefits are often restricted to investments in your own state’s plan.  It’s important to weigh those tax benefits against the costs and available investments in your state’s plan versus other states’ plans.

  12. Many states allow an income tax deduction or credit for 529 plan contributions. While most restrict the tax benefit to contributions to their own state’s plan, a few states allow an income tax deduction for an investment in any state’s plan.

  13. Some states offer matching contributions to an in-state 529 plan.  These are usually tied to income, and the account owner and/or the beneficiary generally must be a resident.

  14. You can take advantage of both 529 plans and other educational tax benefits in the same tax year.  These other tax benefits include the American Opportunity and Lifetime Learning Credits, the tuition and fees deduction, and Coverdell Education Savings Accounts.  You can take advantage of them all, so long as the same expenses aren’t used for more than one tax benefit.

  15. Assets in a parent’s 529 plan have only a limited impact on college financial aid. Colleges generally count only up to 5.64 percent of parents’ assets in their aid formulas.  (But see “The 5 Reasons to Be Cautious,” below, on 529 plan withdrawals from plans owned by grandparents and noncustodial parents.)

  16. There’s a special gift tax benefit.  For gift tax purposes, taxpayers are currently allowed to give anyone up to $14,000 per year tax-free.  (Married couples can give a combined total of $28,000 per year.)  However, a special rule for 529 plans allows contributors to front-load up to five years’ worth of the annual limit gift tax-free.  This means that parents could contribute from $70,000 ($14,000 X 5) to $140,000 ($28,000 X 5) up front with no gift tax cost, allowing interest and dividends to compound that much faster.

  17. Even if 529 plan distributions become taxable, the cost may be minimal in some cases.  If the student beneficiary (or the school) receives the 529 plan distributions directly, and some or all of the distribution is  taxable because it wasn’t used for education expenses, any tax on that amount may be relatively small.  That’s because the distribution is taxable to the student.

    Given that the student may have very little, if any, taxable income, even including the distribution, there may be no tax due, or simply the 10 percent penalty tax (if various exceptions to the penalty don’t apply).

The 5 Reasons to Be Cautious

  1. You could lose money.  Investments in 529 plans are not insured and not guaranteed.  As with any investment in mutual funds, there are both risks and rewards.  Diversification and careful investment selection are key.  Many states offer diversified funds that automatically move to a more conservative allocation as the child approaches college age.

  2. Not all state plans are created equal, so it pays to shop around.  Each state’s plan is unique, and each has a different combination of sales channels, investment offerings, and fees.  These include loads paid for broker-sold plans, enrollment fees, annual maintenance fees, and asset management fees.

    Even if your state offers a tax deduction or credit for contributing to your state’s plan, it’s important to weigh that benefit against the performance and costs of other states’ plans.  You can find annual rankings of state 529 plans at Morningstar, Forbes, and other financial publications.

  3. Your child may decide not to continue his or her education.  As noted earlier, 529 earnings that are not used for education expenses are both taxable and subject to a 10 percent penalty tax.  If your child doesn’t attend an eligible postsecondary institution, and there are no other eligible family members to whom the funds can be transferred, any withdrawals from the account would be taxable and also incur a 10 percent penalty tax.  

  4. You may have to pay back your state income tax benefits or matching contribution.  If the 529 plan funds are not used for education, and you took advantage of your state’s income tax deduction or match for the contributions, you may have to pay the state back, along with any interest or penalties.

  5.  Distributions from 529 plans owned by grandparents, a noncustodial parent, or anyone other than the student’s custodial parent (or the dependent student) are treated in financial aid formulas as income to the student.  These distributions can reduce the amount of financial aid awarded for the next year.  (Careful planning on the timing of these distributions, as well as regarding account ownership, can help to avoid this issue.)