Saving for College: 529 College Savings Plans

Opening a college savings account is a smart way to invest in the education of a family member, a friend or even yourself that often comes with tax benefits.

There are multiple ways to save for higher education, and what works best for you depends on your (or your loved one’s) personal needs and life goals. In this installment of our Saving for College series, we’ll explore 529 college savings plans.

The basics

A 529 plan is a state-sponsored program that allows parents, relatives and friends to invest in a child’s (or any person’s) K-12 and college education. Almost all states and the District of Columbia offer some type of 529 plan. However, you don’t have to live in a particular state to take advantage of its plan.

The term “qualified higher education expense” includes up to $10,000 in annual expenses for tuition in connection with enrollment or attendance at an elementary school, secondary public, private or religious school. Be sure to check with the school’s state 529 plan rules to see if it permits this option.

It’s important to remember that a 529 account belongs to you. While your child is the beneficiary, you remain in charge of the money, which is managed by a fund manager assigned by the state.

Most 529 college savings plans allow you to choose from a variety of predetermined asset allocation portfolios that range from conservative to aggressive, based on historic risk and potential return.

Your plan may offer a choice between an age-based portfolio and a static portfolio. With an age-based portfolio, the fund manager adjusts the asset allocation from more aggressive to conservative as your child nears college age. With a static portfolio, the asset allocation stays the same until you make a change, which you can now do twice per calendar year.

How to open and contribute to a 529 plan

Parents, grandparents and other family members can open a 529 account on behalf of a child or adult at a brokerage or other financial institution, or directly with a state. A person can be the beneficiary of more than one 529 plan at the same time, but you’ll want to make sure the combined contributions don’t exceed the state’s contribution limit.

Most 529 college savings plans allow you to open an account with a small amount—say $25 or $50 a month—if you sign up for an automatic investing plan, with the 529 contributions coming directly from your bank or brokerage account.

Also, be sure to ask whether your employer allows you to make 529 contributions automatically as a payroll deduction, which is a benefit some companies offer.

Tax advantages

Earnings in a 529 plan grow federally tax-deferred, which means your money has a chance to compound faster because you don’t have to pay taxes on current investment income or capital gains. Even better, withdrawals are tax-free as long as you use the money to pay for qualified education expenses, which typically include tuition, books, school supplies and room and board.

Contributions to a 529 are after-tax and not federally tax deductible. However, if you invest in your own state’s 529 plan or if your state is a “tax parity state,”you may benefit from state income tax deductions on contributions or state tax exemptions on withdrawals.¹

You can typically contribute up to $15,000 a year (or $30,000 for couples) without incurring the gift tax. It’s also possible to contribute a lump sum of up to $75,000 to one or more 529 college savings plan in a single year ($150,000 for couples) without being subject to the gift tax. The IRS views the money as an annual $15,000 (or $30,000 for couples) gift over five years. However, if you contribute more money on behalf of the same child during those five years, you may trigger the gift tax.

States can also put a cap on how much can accumulate in a 529 account. Most states set the limit in the $300,000–$400,000 per beneficiary range, though some states have higher limits.

Effect on financial aid

Financial aid formulas typically consider 20% of the assets held in a child’s name available for education expenses. But, as previously mentioned, a 529 plan is considered your asset, not your child’s. As a result, only 5.64% of the money is generally considered available for college expenses after the asset protection allowance (APA).

If another family member (like a grandparent) or non-relative owns the 529 plan, the account assets won’t factor into federal financial aid calculations. However, withdrawals in support of a grandchild will factor into his or her Free Application for Federal Student Aid (FAFSA) or College Scholarship Service Profile (CSS/PROFILE^®) calculations two years after the distribution is made.² In other words, distributions made in a grandchild’s freshman year of college could diminish his or her financial aid during junior year.

Knowing that, one strategy to consider with a grandparent-owned 529 account is to hold off taking any distributions until the last two years of college. That would ensure the distributions won’t affect a grandchild’s financial aid eligibility.  

Saving for college is a wise move, even if you believe your child or grandchild may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid with interest.

Scholarships

If your child receives a scholarship and you decide to withdraw the money from a 529 account instead of changing beneficiaries, you’ll have to pay ordinary income taxes on any earnings above the amount you contributed.

If the withdrawal is more than the amount of the scholarship, you’ll have to pay an additional 10% penalty on earnings for the amount in excess of the scholarship.³ If you withdraw less, the 10% penalty does not apply.

If you simply withdraw the money from your account for any non-qualified purpose, you’ll have to pay federal income taxes as well as a 10% penalty on the full withdrawal amount. 

Non-qualified 529 withdrawals may also be subject to recapture of state tax credits or deductions that you received when making contributions. Consult with a qualified tax advisor for specifics. 

529 prepaid tuition plans

If you know your child will attend a public school in your state, you may be able to take advantage of an alternate 529 plan that allows you to prepay tomorrow’s college tuition at today’s prices.

A 529 prepaid tuition plan provides certain guarantees for tuition and certain expenses at any in-state public school. Some prepaid plans cover tuition, fees, and room and board, while others only cover tuition and fees.

If your child ends up attending an out-of-state or private school, state prepaid tuition plans can be transferred toward these more expensive options; however, they usually only pay the average in-state tuition cost.

There is also a prepaid 529 plan for a consortium of specific private schools.

Alternate options for 529s

If your child decides not to attend college, the funds can be used at any eligible educational institution offering higher education beyond high school, including some overseas, trade or vocational schools eligible to participate in a student aid program run by the U.S. Department of Education. You can see a list of eligible schools on the U.S. Federal Student Aid Code List. 

Funds can also be used to pay for books, supplies and equipment for apprenticeship programs registered and certified with the Secretary of Labor under the National Apprenticeship Act. You can see a list of apprenticeship programs on Apprenticeship.gov.

If there’s money left in your account after your child graduates, you can change the beneficiary to another qualified family member—including yourself. The IRS broadly defines the term family member to include everyone from the original beneficiary’s siblings and parents to step-siblings and in-laws. You can also make a withdrawal up to $10,000 to pay for qualified student loans of the beneficiary or their siblings.⁴

Consider your options

There are a number of resources for financial aid information, including the U.S. Department of Education and College Board. However, it’s always a good idea to check with your financial planner and a qualified tax advisor to determine which education savings route is best for you and your family.

¹States that offer a “tax parity” tax deduction for contributing to a 529 plan, including out-of-state plans that may be more attractive than the in-state option, include Arizona, Kansas, Minnesota, Missouri, Montana and Pennsylvania.

²About 400 schools and scholarships use CSS PROFILE^® as part of their financial aid process. Additional financial assets and resources can be considered in the CSS PROFILE that are not considered in the FAFSA. Contact the institution for more information.

³Scholarships or grants are tax-free if the individual is a candidate for a degree at an eligible institution and the amounts are used for specific expenses. See IRS Publication 970 for more details.

4Student loan interest paid by any portion of the $10,000 as a tax-free withdrawal cannot also be deducted for federal taxes.