What is a 529 Plan?

A 529 plan is a tax-advantaged savings account that is used to help pay for college. It was initially confined to post-secondary education fees, but in 2017 and 2019, it was expanded to include K-12 education and apprenticeship programs. Savings programs and prepaid tuition plans are the two primary forms of 529 plans.

Savings plans grow tax-deferred, and withdrawals for eligible school costs are tax-free. Prepaid tuition plans allow account holders to pay for tuition at specific colleges and universities in advance, locking in today’s rates. Qualified tuition programs and Section 529 plans are other names for 529 plans.

529 Plan Tax Benefits

A 529 college savings plan invests your after-tax contributions in mutual funds, ETFs, and comparable investments, similar to a Roth 401(k) or Roth IRA. Your money will grow tax-deferred and can be withdrawn tax-free if it is used to pay for eligible higher education expenditures. Contributions are not tax-deductible in the United States.

You may also be eligible for a state tax credit, depending on where you live. State income tax deductions and credits for 529 plan contributions are available in more than 30 states.

Because donations are considered completed gifts to the beneficiary, some families use 529 plans as an estate planning tool. The annual gift tax exception is worth $15,000 per donor and beneficiary.

How does the 529 Plan work?

Anyone can contribute to a 529 account once it has been established. The account owner must submit a withdrawal request to the plan administrator to withdraw funds, indicating whether the withdrawal is qualified (explained later) or nonqualified. By January 31 of the following year, the recipient should have received a Form 1099-Q, Payments From Qualified Education Programs, specifying the entire withdrawal amount and the components that are deemed earnings vs. a return of investment.

To the extent that earnings exceed “adjusted eligible education expenditures,” the earnings component may be liable to tax plus a 10% penalty. Qualified education expenses minus tax-free educational assistance and the amount used for the American opportunity tax credit (maximum $4,000 in expenses; maximum credit $2,500) equal adjusted qualified education expenses.

Types of 529 plans

Prepaid tuition plans:

You can lock in current tuition prices at public colleges and universities in your state. If your child opts for a private or out-of-state school, you may only get a minimal return on your initial investment.

Savings plan:

You make monthly contributions and count on the account’s earnings to grow. You take on additional financial risk in exchange for your child’s ability to spend the funds at public and private schools around the country.

How Much Can I Contribute?

Although there are no annual contribution restrictions for 529 plans, there are a few factors to consider when making a significant commitment. Contributions beyond the yearly gift tax exclusion ($15,000 in 2021) will, for example, be deducted from your lifetime estate and gift tax exemption ($11.7 million in 2021).

In addition, each state has a contribution limit for 529 plans that range from $235,000 to $529,000. This figure is based on the cost of attending a prestigious college or graduate program, including textbooks and living expenses.

It would help if you strived to save around one-third of your expected future education costs as a general rule of thumb. This presupposes that you can cover the remaining two-thirds of your income from existing sources, such as scholarship funds and student loans.

Tax Advantages of 529 Plan

If the money is utilized for approved school costs, the earnings in a 529 plan are tax-free on both the federal and state levels. Except for specific conditions, such as death or disability, all other withdrawals are subject to taxes and a 10% penalty.

The money you put into a 529 plan isn’t deductible for federal income tax reasons. Contributions to a 529 plan, on the other hand, are eligible for tax deductions or credits in more than 30 states. If you desire a state tax deduction or credit, you should generally invest in your home state’s plan. Some states will enable you to invest in their plans as a nonresident if you’re ready to forego a tax incentive.

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