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Updated on Thursday, February 5, 2015
You may have heard talk recently about 529 plans and how they may no longer be a good place to put your college savings.
In the State of the Union address on January 20, Obama proposed eliminating some of the tax benefits associated with 529 plans. But he has since backtracked, and 529 plans are as alive and well as they have ever been.
It may still make a lot of sense for you to use a 529 plan, but first you need to understand how 529 plans work and how they can make it easier for you to save for your child’s college education.
How do 529 plans work?
529 plans are special investment accounts that make it easier to save for college by giving you some pretty big tax breaks. In fact, 529 plans work a lot like Roth IRAs, just for college instead of retirement.
Just like a Roth IRA, there’s no Federal tax deduction on the money you contribute (we’ll talk about state taxes in just a second). But the money grows tax-free while it’s inside the account, and if it’s withdrawn for qualified higher education expenses (read: college and beyond), it also comes out tax-free. Just like a Roth IRA!
But 529 plans have one more big potential tax benefit that Roth IRAs don’t have. Some states allow you to deduct your contributions for state income tax purposes if those contributions are to your home state’s plan. That deduction can make it even easier to save.
The benefits of 529 plans
The big benefit of using a 529 plan is the tax breaks. Other than a Coverdell ESA, which is also a great option, there’s no other account where you can get this kind of tax benefit for your college savings.
But there are some other benefits as well.
When you open a 529 plan, you’ll have to name a beneficiary, which is simply the child for whom you’re saving. But if that child doesn’t end up needing all of the money you’ve saved for college, you have the option of changing the beneficiary to another child, or even to yourself, your spouse, or eventually to a grandchild. That gives you some flexibility to use the money where it’s needed instead of having it go to waste.
There are also very few contribution limits with 529 plans. There are no income restrictions, so anyone can contribute and still get the same benefits. And you’re generally allowed to contribute up to $14,000 per child per year, with married couples allowed to contribute $28,000 per child per year. There are even special cases where you could contribute up to 5x that amount in a given year. A benefit the Obamas actually took advantage of in 2007 when the couple contributed $240,000 to a 529 plan for their daughter’s educations.
Finally, it’s worth noting that 529 plans are run by states, with each state having one or more plans. But you’re under no obligation to use your state’s plan. So if your state’s 529 plan comes with high fees and/or poor investment choices, you can simply choose another plan. The only time you would be obligated to go with your state’s plan is if you’re looking to get that state income tax deduction. Otherwise, you’re free to go with the best option.
The downsides of 529 plans
While there are some great reasons to use a 529 plan for your college savings, there are some downsides to be aware of too.
The biggest downside is the penalty you would face if you wanted to use the money inside your 529 plan for something other than education expenses. Withdrawing it for any other purpose would not only cause that money to be taxed, but to be hit with a 10% penalty.
There are some exceptions to that 10% penalty. If your child receives a scholarship, you can withdraw up to the amount of the scholarship without penalty. And there are exceptions for death or disability as well, but beyond that, your flexibility is limited.
And unlike a Coverdell ESA, money within a 529 plan can’t be used for K-12 expenses (without facing that withdrawal penalty). Only higher education expenses qualify for tax-free withdrawals.
Finally, your investment options within a 529 plan are limited, though that’s not always a bad thing. It’s kind of like a 401(k), but it’s the state choosing your investment options instead of your employer. And just like with 401(k)’s, some states make good choices and others make bad ones. The good news is that you’re not locked into any one state’s plan, so you can certainly shop around.
How do 529 plans affect financial aid?
Some parents are afraid to use a 529 plan because they’ve heard that it will hurt their eligibility for financial aid. And I’m here to tell you NOT to worry about that.
Here’s the deal: 5.64% of the money you have inside a 529 plan will be counted as part of your financial aid eligibility. Which means that 94.36% of it WON’T count. At all. And the truth is that any money you have outside of your house or retirement accounts will be counted in exactly the same way.
In other words, it’s much better to save ahead and have the money available than to not save and avoid that small ding towards financial aid. Especially when you consider that most financial aid comes in the form of loans anyways, which we all know isn’t exactly free money.
There is one catch to worry about with 529 plans and financial aid though, and it involves grandparents.
Grandparents can open a 529 for their grandchildren, but if they actually withdraw money to pay for that child’s college expenses that withdrawal will count as the child’s income for financial aid purposes. And since the child’s income is the factor that counts the most against financial aid eligibility, this can be a big issue.
There are a couple of ways for a grandparent to contribute to a 529 plan and avoid this issue:
- Grandparents can contribute directly to a parent-owned 529 plan, instead of opening their own. The big downside with this tactic is that the money is then controlled by the parents, not the grandparents, which may or may not cause a family conflict.
- Grandparents could simply wait until the child’s last year of school before they help with expenses. Without another financial aid application on the horizon, the consequences won’t make a difference.
Bottom line: 529 plans are still a great tool
If you’re ready to save money specifically for college, a 529 plan is still a great option.
The tax advantages make it easier to save without busting your budget, especially if your state gives you an income tax deduction.
And with the flexibility to choose any state’s plan, contribute almost as much as you want, and change beneficiaries at any time, you can make it work for you no matter what your situation.