What Is a 529 Plan and How Does it Work? - MagnifyMoney

What Is a 529 Plan and How Does it Work?

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Let’s face it: Saving for college is a monumental task. Thankfully, a 529 plan can make saving for K-12, college and apprenticeship program expenses easier.

When you save in a 529 account, your investments grow tax-deferred. Then, you can make tax-free withdrawals to pay for qualified education expenses. And we aren’t talking about just tuition costs, either. You can also cover books, room and board, supplies and even repay student loans.

What is a 529 plan?

A 529 plan, which the IRS calls a “qualified tuition program,” is a tax-advantaged investment account that helps you save money for educational expenses. Initially, you could only use 529 account funds for higher education (like college), but that’s changed to bring you even more educational savings benefits.

You can now use 529 accounts to cover up to $10,000 in K-12 tuition per person each year at a private, public or religious elementary or secondary school. You can also use 529 plan funds toward trade schools, vocational schools and apprenticeships, as well as qualified education expenses (like tuition, room and board, books and other related expenses, including computers and internet) without penalty.

Already have college expenses you’ve paid for with loans? No problem. You can also use 529 funds to repay up to $10,000 in student loans.

And here’s another bonus: Any U.S. resident can open a 529 account. That means anyone with a Social Security or Tax I.D. number can be a 529 plan beneficiary — even if you’re the one who opened the account.

Types of 529 plans

There are two types of 529 accounts: college savings plans and prepaid tuition plans. Every state offers at least one type of these two plans.

College savings plans

A 529 college savings plan works much like a Roth IRA or Roth 401(k). Your investments, typically mutual funds and exchange-traded funds (ETFs) grow tax-deferred. Then, when you’re ready to use the funds, your withdrawals are tax-free if used for qualified expenses, such as:

  • College tuition
  • College room and board
  • K-12 tuition up to $10,000 per year
  • College technology, like computers, printers, internet and software required for school
  • College books and educational supplies, from lab supplies to paper and pens
  • Student loan repayment up to $10,000 per person
  • Apprenticeship program costs
  • Vocational school
  • Trade school

Another plus for 529 college savings plans: You can change the plan’s beneficiary until you begin taking withdrawals — especially helpful if the intended beneficiary doesn’t attend college. In this case, you can transfer the plan to another beneficiary, including other children, immediate relatives and even relatives by marriage.

However, there is one downside to 529 plan accounts.

Any funds you withdraw that you don’t use for qualified education expenses get penalized. So you’ll pay not only ordinary federal income taxes on those withdrawals but also a 10% penalty on the earnings. The only exception is if the plan beneficiary gets a full scholarship for college.

Prepaid tuition plans

Prepaid tuition plans help you capture today’s tuition at today’s rates for tomorrow’s education.

Instead of putting savings into investments that may grow in value over time to help fund a college education, 529 prepaid plans act more like installment loans for college tuition. The options vary by state, but you typically contribute via a lump sum (perhaps by the grace of generous grandparents) or through installments until you fully pay for the number of credits, units or years you’ve pre-purchased.

Nine states offer prepaid tuition plans, including Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas and Washington. Some states, like Illinois, previously offered pre-paid plans but have closed their enrollment.

However, if you don’t reside in one of those states, you can still enroll in the Private College 529 Plan. It is the only national prepaid tuition plan and includes nearly 300 private colleges and universities in its network.

What’s the upside of a prepaid 529 plan? First, the price of college tuition is predetermined. If the rates go up, you’ve locked in cheaper costs. Many prepaid tuition plans will let you transfer the account to another child, too.

But prepaid tuition plans also have some significant drawbacks. For example, plans may impose residency requirements and limit participation only to residents of the state. And unlike 529 college savings plans, you can’t use prepaid tuition plans for K-12 tuition, room and board or other qualified educational expenses.

And then there’s the issue of a beneficiary who decides not to attend college.

Suppose your child doesn’t want to attend college within the prepaid tuition network, and their sibling doesn’t want to use the plan. In that case, most plans will only give back the money you contributed, less fees and a reduction of any interest earned.

529 plan contribution limits and rules

The IRS and individual states each have rules that govern who can contribute to a 529 plan and how much.

Who can contribute to a 529 plan?

Here’s one time where the IRS is on your side: Anyone can contribute to a 529 plan, no matter the beneficiary or account owner. Whether a family friend or a close relative, there are no restrictions.

How much money can you put in a 529 per year?

While there isn’t an annual contribution limit for 529 accounts like there is with various retirement plans, you’ll want to be conscious of the annual gift tax limit.

For 2022, you can individually contribute up to $16,000 per person per year (or $32,000 per couple) without triggering the gift tax or giving up part of the lifetime gift exemption.

If you contribute more than $16,000 per year, you’ll need to file a gift tax return.

Aggregate contribution limits

Many plans have a maximum aggregate contribution limit of $500,000 or more. However, some come in considerably lower. If you plan on saving a substantial sum for educational expenses, you may consider a plan outside your home state with a higher aggregate limit.

However, keep in mind that choosing an out-of-state plan means losing in-state tax deductions for your contributions (if applicable).

States with the highest aggregate limits (per beneficiary)

  • New Hampshire — $553,089
  • Missouri — $550,000
  • West Virginia — $550,00
  • North Carolina — $540,000
  • California — $529,000

States with the lowest aggregate limits (per beneficiary)

  • Mississippi — $235,000
  • Georgia — $235,000
  • North Dakota — $269,000
  • Hawaii — $305,000
  • New Jersey — $305,000

529 plan tax benefits

While 529 plans don’t score any tax deductions at the federal level, they offer decent state-level tax perks if you qualify.

If you enroll in a plan in your state of residence — and that state has a state income tax — you can potentially deduct a portion of your contributions from your state taxes.

For example, Illinois residents contributing to the state’s BrightStart plan can deduct up to $10,000 in contributions ($20,000 for married couples) on their state income taxes each year. However, Arizona caps deductions at $2,000 per individual and $4,000 per married couple. As deduction limits vary by state, review your state’s plan thoroughly before filing your taxes.

A final word on 529 plan tax benefits: If you enroll in a plan in a state where you’re not a resident, you won’t be able to deduct your 529 plan contributions on your home state’s income taxes.

How to open a 529 plan

How you open a 529 account depends on your state and the type of plan. To get you on your way, here’s a step-by-step process to help you open a 529 plan:

  1. Decide which plan to open. It pays to shop around with so many options between college savings plans and prepaid tuition plans. Also, be sure to consider any state income tax deductions you might lose if you go with an out-of-state plan.
  2. Decide who will open the account. Plans usually only allow one parent to be the account holder. Tip: The account holder will be the one who files the federal student financial aid application.
  3. Complete the plan application. You’ll need to designate the account holder and plan beneficiary and provide taxpayer ID information.
  4. Make your first deposit. Plans typically have several ways to fund your account, including ACH transfer, mailing a check, wire transfer, etc.
  5. Select investments (if opening a 529 college savings plan). Once your account is open, you’ll be able to review investment options. Be sure to review the annual expense ratio for each option as those costs can chip away at your returns.
  6. Consider automatic savings. Most plans give you the ability to set up recurring contributions. If that’s not your cup of tea, you can make contributions as you’re able to.

What’s next?

Education savings is a big subject, for sure. But before you start saving for future school expenses, it pays to take care of other parts of your finances today.