A 529 plan is a tax-advantaged saving plan that allows invested funds to both grow and be withdrawn tax-free for qualifying educational expenses. Also called “qualified tuition plans,” 529 plans are sponsored by individual states or state agencies as well as by educational institutions.
It’s important to research your options carefully to find out what tax breaks are available where you live, as different states and schools have different 529 plan rules. There are different kinds of 529 plans as well, so you’ll need to decide which is right for your family. This guide can help.
What is a 529 plan?
Two types of 529 plans exist that provide tax breaks on federal and state taxes:
- Prepaid tuition plans: These plans involve purchasing credits at colleges or universities at the current price for someone who will attend school in the future. Most plans are sponsored by state governments and allow tuition and mandatory fees to be prepaid at public and in-state institutions. Students must attend a participating school to get the full value of prepaid credits.
- Education savings plans: These plans involve putting money into an investment account and using the money to buy assets such as exchange-traded funds or mutual funds. Money can be withdrawn to pay for tuition, room and board, and mandatory fees at any university or college.
Education plans provide more flexibility, but account holders must choose what to invest in, and the investments could lose money. Target-date funds that automatically invest in an appropriate mix of investments simplify the process of selecting investments, but there’s still no guarantee investments will perform well.
Of course, there’s also a risk with prepaid tuition plans unless they’re guaranteed by the state. Some states guarantee the funds, but if your state doesn’t, you could lose some of your investment if the plan sponsor runs into financial problems.
What are the 529 plan rules?
One big benefit of 529 plans is that almost anyone can open one, including parents, grandparents, relatives, friends, and even some corporations. Students can open 529 plans to save for their own college expenses if they are 18 or older.
Whoever chooses to open the account should understand the difference between the account owner and the beneficiary. The child who uses the funds to go to school is the beneficiary. The money is used to benefit that child by covering school costs; however, the child doesn’t have ownership or legal control over the money — unless they are over the age of 18 and open an account for themselves, making them both the owner and beneficiary.
Anyone can be the account owner, but it’s usually a parent. Ownership also can be transferred, with the original owner naming a successor owner. This is helpful when grandparents open an account and then name the child’s parent as a successor owner, for example.
Assets in a 529 savings plan owned by a parent or dependent child are considered parental assets on the Free Application for Federal Student Aid (FAFSA). If any 529 funds exceed the Asset Protection Allowance limit (typically around $10,000), that will decrease the student’s FAFSA aid by up to 5.64% of the account’s value.
What can 529 funds be used for?
While 529 account rules vary by plan, funds generally can be used only for qualifying educational expenses.
If the account is a prepaid tuition plan, funds can cover only tuition and mandatory fees, not room and board. Additionally, funds can pay for those costs only at participating colleges and universities, so if a student chooses to attend a different school, the plan pays for less. If the beneficiary of the plan chooses not to go to school, funds can be transferred to a different beneficiary.
If the account is an education savings plan, the money can be used at almost any college or university and can pay for tuition, room and board, and mandatory fees for undergraduate, graduate or professional programs. The money also can be used to pay up to $10,000 annually for each beneficiary for tuition at public, private or religious elementary or secondary schools.
Contribution limits of 529 plans
Unlike many tax-advantaged accounts, there are no annual contribution limits; however, there’s an aggregate limit that varies by state. Typically, you can’t contribute more than the expected costs of higher educational expenses. 529 plan rules vary by state, but limits typically range from $235,000 to as much as $529,000.
While there’s no annual contribution limit, taxes can be triggered if a particular contribution is too large since contributions are treated as gifts. In tax year 2020 and 2021, a person can give a gift valued at up to $15,000 per recipient without owing gift taxes. That means a relative or friend can contribute up to $15,000 into a 529 without triggering taxes. Additionally, gifts above the annual limit can count toward a lifetime exclusion that allows for $11.58 million in 2020 and $11.7 million in 2021 per person to be transferred without owing taxes.
529 plans also give you the option to contribute a lump sum of up to $75,000 without triggering gift taxes. That’s because the five-year election option allows you to prorate contributions of $15,000 of more over a five year period. When you make a $75,000 lump-sum contribution, it’s treated as if you’d contributed $15,000 annually over five years.
529 withdrawal rules
Money from a 529 must be withdrawn during the year the beneficiary incurs qualified higher education expenses (QHEEs). Any funds withdrawn to pay for QHEEs will be considered qualified distributions and can be withdrawn tax-free.
Penalties and taxes come into play if money is withdrawn to pay for anything other than QHEEs — or if a child hasn’t incurred enough QHEEs in the tax year to account for the withdrawals. You’ll need to be careful not to withdraw funds in December to pay tuition in January if the child didn’t have enough QHEEs in the year the money was taken out.
There’s one exception to this penalty, though: If the beneficiary receives a scholarship, funds can be withdrawn from the 529 account to offset the scholarship value, and only ordinary income tax will need to be paid.
If you claim the American opportunity tax credit …
Anti-coordination rules also require that you reduce the amount of QHEEs in a year if you claim the American opportunity tax credit or lifetime learning credit. For example, if a child incurred $5,000 in educational expenses but you claimed a $2,500 American opportunity tax credit, you’d have only $1,000 in qualified educational expenses because $4,000 of the money spent on tuition was necessary to justify claiming the tax credit. If you don’t comply with this rule, you’ll owe ordinary income taxes on any money withdrawn — but not the 10% penalty for other nonqualified withdrawals.
If you take out too much money …
If you withdraw too much, you can roll the money into a different 529 plan to avoid penalties. However, you must act within 60 days of the withdrawal, and must not have rolled over money from the same beneficiary’s 529 in the past year. If a period of more than 60 days has passed and you’re still within the calendar year, you can prepay expenses to increase your QHEEs. If the tax year has ended, however, you won’t be able to roll the funds over and then will be required to pay the penalty.
State and federal tax breaks are available for 529 plans, but 529 plan rules vary by state. While these 529 plan rules are complicated, it’s important to understand them so you can reap all the benefits of investing in a 529 and make saving for college a little easier. If you’re wondering if a 529 plan meets your investment goals it may be a good idea to discuss the decision with an investment advisor.