One of the many financial mistakes I made when I was younger was failing to start a college saving 529 plan for each one of my children. The tax benefits and the power of compound interest are something I neglected to learn about, which will cost me when my kids start college.
If you have young kids, learn from my mistakes and educate yourself on the power of these awesome tax-advantaged plans.
Warning: This post is quite long. To make the information easier to digest, use the table of contents below to skip to sections you would like to learn about.
How Does a 529 College Plan Work?
The idea of the 529 college savings plan was created in 1996 by Congress. This is a savings plan designed to be used for the tax advantages of saving for a child’s educational expenses.
Each state has its own specific 529 plan that students can take advantage of. With this, there are different tax implications and deductions that may apply depending on what state you live in and what state provides the 529 plan.
Anyone can open one of these accounts for a child and can immediately begin to take advantage of the power of compound interest by investing in stocks and mutual funds. Within these plans, the available investments include age-based options and conservative stocks and bonds.
Although most people believe this type of account is just for qualified educational expenses for children, the account offers benefits other than tuition and college expenses.
Use A 529 Plan For Private School!
Due to tax law reform, residents of specific states are able to make a maximum annual withdrawal of $10,000 to pay tuition expenses for Kindergarten through 12th grade!
Tax Benefits By State
Some states allow you to deduct your 529 contributions from your taxed reported income each year. See if your state allows for these additional tax benefits. Keep in mind you can only claim deductions in the state of your residence.
A 529 college savings plan can also be opened by the student as a savings account for graduate school. The plan is classified as a specialized savings account with the purpose of saving money to pay for college.
In addition, the investments of every 529 plan are controlled by the account owner, so your kids are not the ones making financial investment decisions. The owner also chooses a beneficiary and one additional beneficiary.
The tax-free funds in the 529 account can be used to pay for the tuition of the beneficiary for kindergarten through 12th grade in addition to college expenses. This includes books, supplies, and equipment.
The 529 plans have worked well for numerous families by providing a means of meeting college savings goals. The plan makes saving money easier due to the option for scheduling investments automatically for as little as $15 to $25 per month. The funds can be transferred through a payroll check or bank account.
How Much Can I Put In A 529 Each Year?
The maximum tax-free gift is $17,000 per beneficiary for each contributor for the year 2023. This means a married couple filing taxes jointly is able to contribute $30,000 each year under the federal gift exclusion.
If this amount is exceeded, the taxpayer will be responsible to pay an additional gift tax to the IRS (Internal Revenue Service).
Another option is called “superfunding“. A maximum of $150,000 per couple or $75,000 per individual can be placed into the account up-front without a gift tax for five years. This exercises the annual gift tax exclusion ahead of time. No additional gift tax exclusions will be able to be used for the next 5 years.
If you choose this option, additional specific paperwork will need to be filed at the end of the year to inform the IRS.
The maximum amount able to be accumulated in a 529 account is dependent on the state. A good example is ScholarShare529 in California. The maximum balance allowed in the account is $475,000.
What Are the Pros and Cons of a 529 Plan?
The pros include:
- The funds in a 529 account will continue to accumulate tax-free prior to a withdrawal.
- Depending on the beneficiary’s home state, the funds can accumulate tax-free until a withdrawal is made for qualified higher education expenses. The home state offers slightly different benefits than the other states.
- Contributions can be made by anyone. However, the best option for the account holder is a parent due to the tax benefits.
- If all of the funds are not used by the child, the beneficiary of the account can be changed to a direct relative. This makes the account flexible and able to withstand several different generations.
- There are financial-aid advantages for a 529 plan. The federal application determining eligibility for financial aid is generally 20 percent of all assets held by the student. When the 529 is owned by either the parents or the student, just 5.64 percent of the account is considered an asset.
The cons include:
- Future tax regulation changes can impact existing 529 plans and how the money can be used.
- 529 plans can be restrictive. Once an investment is made, the funds can only be used for education. If funds are withdrawn for any other reason, there are penalties, including a federal penalty tax. State income tax may also be due.
- Determining what qualifies as education expenses can be confusing. Dorm rooms are not always included in the price of postsecondary educational institutions or community colleges. The 529 may not always be used for paying these expenses, in addition to potential exceptions for tuition-free books and unqualified higher education expenses.
- Depending on who opened the account and the way the 529 was established, maintaining the account may incur higher fees.
- The funds may not be used for pre-college expenses such as application fees and campus visits.
Even with these numerous possible issues, in my opinion, the pros of tax-free growth and tax-free withdrawals make the 529 plans a no-brainer. The pros absolutely outweigh the cons.
How To Fund A 529 Plan And The Minimum Requirements
There are different options for making a deposit into a 529 plan. The funds can be electronically transferred from a bank account, or a paper check can be mailed directly to the 529. All plans allow automatic bank account contributions.
The amount and frequency must be specified including annually, quarterly, monthly, and biweekly. The 529 account requires the account and routing numbers and a voided copy of either a preprinted deposit slip or a preprinted check. Certain plans allow participating employers to authorize a payroll deduction for an automatic contribution.
Most people find it easier to save money by making an automatic investment. The additional options include funds from redeeming a qualified United States savings bond, funds from an existing Coverdell educational savings account, or rolling over funds from another 529 account.
Minimum 529 Plan Contributions
The minimum 529 plan contributions are based on the state, while some states do not have a minimum contribution.
Automatic contributions must be a minimum of $15 or $25, depending on the plan. There are no yearly limits for contributions, but if $15,000 per individual is exceeded, the IRS does charge a gift tax.
The state’s 529 plan offers an average of five years prior to a gift tax. This means five times the yearly limit can be contributed in one-year and treated as contributions over a period of five years. The limits for cumulative yearly contributions also vary according to state, varying from $235,000 to $529,000.
Depending on the year and the economy, adjustments may be made periodically for inflation. Once a 529 account has reached the maximum balance, the balance will continue to appreciate and earn interest, but further contributions are denied.
The Overall Maximum A Beneficiary Can Earn
On average, the maximum total contributions for a 529 account for a beneficiary cannot exceed $400K-$500K, depending on the state. The average plan never reaches this limit. Keep in mind this is only for contributions. As stated earlier, the fund can continue earning interest and increase its worth.
The majority of 529 plans receive small, automatic contributions each month. The amount often increases as time passes. The goal is to save approximately one-third of the cost of a public college education in the future. The best way to meet this goal is to save $250 each month from the birth of the child. Most people simply contribute what is affordable.
How Much Does The Average Family Save For College?
According to a Sallie Mae study, the average amount families are able to save for college is approximately $18,135. This dismal number will only cover 1-2 years of college, depending on the school. Universities are obviously more expensive than community colleges, so this balance can quickly run out resulting in large student loan bills.
Are 529 Plans Worth It?
As parents, we must make the determination as to how much money we can set aside for our children’s education. I don’t want to set my kids up for failure by making them take out student loans they will spend the next 30 years trying to pay off.
If you’re on the fence about these plans, understand that time is not always in our favor. Before you know it, your kids will be grown and ready for college and facing ever-increasing college fees. If you can start packing away small amounts of money to take advantage of time and compound interest, you will save tens of thousands of dollars on their future education expenses.
There are many reasons savvy financial couples have decided a 529 plan is worth it. The amount of time the family has to save for college is limited. A 529 plan offers better benefits than the low-interest rates offered by saving accounts.
If a child will not be attending college for at least ten years, an investment in a 529 plan can compound the returns to enable the money to go to work. As parents, we can greatly reduce our college expense worries and future costs.
One of the main reasons families open a 529 plan is for tax advantages. These advantages enable additional funds to be saved for educational expenses. Depending on the needs of each individual family, there are several different plans available.
You do not have to choose the 529 plan offered by your home state.
If the state offers a good deduction for using the state plan, it is an excellent option. If there is a minimal or no deduction, some families choose a plan from another state due to the better investment options and lower fees.
529 Vs. Custodial Accounts
When my children were younger, I opened custodial accounts for them, so their birthday money didn’t sit in a savings account. However, at that time, I should have also started 529 plans for them.
A 529 is different from UGMA/UTMA custodial accounts because the child does not control the funds once reaching legal age. The owner of a custodial account can withdraw money for any reason at any time but does not get the tax benefits a 529 plan offers.
The 529 plan is flexible because twice each calendar year, the investment options can be changed. For each 12-month period, funds can be rolled over from one 529 plan to another. If another qualifying family member replaces the beneficiary, the frequency of changes is not limited by the federal government.
A 529 plan is simple, easy, and low maintenance. Families can save efficiently for their children’s education. There are numerous financial advisors offering to set up 529 plans for their clients for a small fee. The advisor will explain the different plans available and the best benefits of each one and help ensure the family has the ideal plan for their circumstances. Financial advisors should also stay current regarding any legal changes made to the plans.
Setting up automatic investments linking either a payroll deduction or bank account to the plan makes certain investments are made.
Everyone is eligible to establish a 529 plan. As opposed to Coverdell Education Savings Accounts and Roth IRAs, there are no yearly contribution limits, age limits, or income limits with a 529 plan.
A 529 plan simplifies tax reporting because contributions are not included in federal tax returns. No Form 1099 is received for nontaxable or taxable earnings until a withdrawal has been made on the account. The deposit amount increased in 2018 to $30,000 per married couple or $15,000 per individual to qualify for the yearly tax exclusion.
What Happens To My Kid’s 529 Plan If They Don’t Go to College?
The 529 plan takes into consideration the future is never certain. For this reason, parents will not lose their money if their child is awarded a financial aid scholarship or decides not to go to college. If there are no other children you can transfer the account to, there are still other options.
If there is no one else in the family that is going to go to college, think grandkids, you can still pull money out of the 529 plan. In most instances, the parents will have to pay a penalty and income tax on any non-qualified withdrawal. All of the tax breaks will be forfeited, but your money is not locked up.
There are exceptions where the tax penalties are waived:
• The beneficiary becomes disabled or dies
• The beneficiary attends a United States Military Academy
• The beneficiary is awarded a tax-free scholarship
The earnings will still be subjected to federal income tax. In some cases, state income tax is applicable as well.
What Happens To Left Over Money Not Used In A 529 Plan?
Funds can be withdrawn from a 529 plan at any time for any reason. Non-qualified withdrawals will be charged a penalty and taxes. The account holder should understand the potential tactics and rules for decreasing taxes for non-qualified withdrawals. There are also options to avoid paying a penalty or taxes on the earnings, including:
- The funds can be held in the 529 accounts in case the beneficiary attends grad school at a later date.
- The account holder can further their education by becoming the beneficiary of the account.
- The beneficiary can be changed to a different qualifying family member
- A new option was added on January 1st of, 2018. Parents can pay for K-12 tuition with a tax-free withdrawal for a maximum of $10,000.
- The funds can be rolled over into another 529 account or a 529 ABLE account. The latter is a savings account created for individuals living with a disability.
Use a 529 Plan to Pay Off Student Loans
In December of 2019, President Donald Trump signed a law making student loans a qualified expense for 529 plans. The SECURE Act is the spending bill establishing a $10,000 lifetime limit for 529 plans. The funds can be used to repay student loans, including most private loans and federal loans for the student beneficiary.
Another $10,000 can be used for the repayment of student loans for all of the beneficiary’s siblings. Prior to the above changes being made, when payments were made for student loans, penalties and income tax were due. The new rules for 529 plans are retroactive, beginning on January 1st of, 2019.
How Safe Is Your Money?
Any funds left in a 529 plan will not be lost. The funds can either be applied to post-secondary education or used for a qualified family member as a beneficiary, including younger siblings, grandchildren, nephews, nieces or even for the account holder.
The full amount of a scholarship award can be withdrawn with no penalty from a 529 plan. State and federal income taxes will still apply to the earnings. If withdrawal becomes necessary for expenses unrelated to education, a 10 percent penalty in addition to taxes on the earnings may be owed.
Distributions from the plan consist of earnings and contributions proportionate to the corresponding levels for the account. The withdrawal portion consisting of contributions remains both penalty and tax-free. The withdrawal portion consisting of earnings is subjected to both the 10 percent penalty and taxes.
What College Saving Plan is Best?
There are two key types of 529 plans, custodial accounts and individual accounts. The best 529 plan is dependent on the specific needs of the account holder and beneficiary. The majority of 529 accounts are opened as individual accounts. The beneficiary is the child, and the account owner is the parent.
Contributions can be made to a parent-owned plan by anyone, including grandparents, uncles, aunts, parents, and other relatives. In most cases, the account owner can only be one of the parents.
If the parents of the child are divorced, the parent with the responsibility of filing FAFSA should be the account owner. If the parent has married again, the biological parent should be the account owner as opposed to the stepparent.
If the 529 plan is funded from a brokerage account, including a UGMA or UTMA account or a custodial bank, the plan should be opened as a custodial 529 plan. With this type of plan, the child acts as both the beneficiary and the account holder. If the child is a minor, the account will be managed by a custodian for the child until the child reaches majority age.
A custodial 529 account beneficiary is unable to be changed.
The formulas used by financial aid look more favorably on a 529 plan when the owner is either the parent of the student or a dependent student. If the 529 plan is opened by the grandparents as the owner of the account, the eligibility of the student to qualify for financial aid or AID scholarship funds can be compromised.
A plan owned by grandparents does not need to be reported on FAFSA as an asset. The reason the ownership can impact financial aid is that distributions from a 529 plan owned by grandparents are considered untaxed income for the beneficiary by FAFSA.
The result is a reduction in eligibility by a maximum of half of the amount distributed. The negative impact regarding eligibility for financial aid for 529 plans owned by a grandparent can be worked around in several different ways.
529 Plans Vs. Traditional Mutual Funds
There are several reasons why a 529 plan is better for college than traditional mutual funds. Despite the argument that higher returns are generated by mutual funds as opposed to a 529 plan, the latter is more beneficial. The reasons are defined below.
Taxes For Capital Gains And Income
Mutual funds require some taxes to be paid, and 529 plans do not. Investments in mutual funds generally require capital gains distributions at the end of the year. If college expenses are covered by liquidating a mutual fund, taxes must be paid on the appreciation. Due to the Affordable Care Act, high-income households must pay an extra investment income surtax.
Earnings from qualified 529 and tuition plans are excluded from this taxation.
Child Tax
Most people believe giving an investment or monetary gift to a child enables them to take advantage of a much lower tax bracket. The issue is if the income earned by the child exceeds a defined threshold, the taxation will be at the marginal tax rate of the parents. This rule is also applicable to certain non-self-supporting full-time college students.
Investment Objectives Risks
The majority of financial planners recommend decreasing equity exposure risks for college savings portfolios the moment the child is getting ready to attend college. Since mutual funds are taxable, transferring funds will result in triggering potentially costly gains for taxes.
An age-based option is offered by most 529 plans to ensure allocations are automatically shifted. Numerous plans are available, with tactical management offering flexibility for changing market conditions.
Underlying investments are simply reallocated. The owners of 529 plans have the ability to change their investment options once every calendar year. None of these steps will trigger a tax for capital gains.
Financial Aid
All income showing up on Form 1040 can have a major impact on eligibility for financial aid for the next year, including capital gains. If the only way to cover college expenses is by using appreciated investments, any chance of the child being approved for need-based aid is most likely eliminated.
No income needs to be reported from a 529 plan on Form 1040 because distributions are tax-free. The result is the preservation of eligibility for financial aid.
529 Plan Expenses
Due to the extreme competition between investment firms to secure management contracts by winning state bids, manager fees for plans have continued to decrease. Low-cost index funds are offered by numerous 529 plans as an investment option to decrease the cost even more.
Extensive modeling has been performed to determine if the tax benefits for a 529 plan are eliminated by additional expenses. The results showed this only happened under rare circumstances when the investor is in a low-income bracket, and the expenses of the plan were still fairly high.
Investment Management
Even tax-managed mutual funds have tax consequences for investment decisions. This is not necessary for 529 plans because the investment decisions are based on the investment considerations of the investor.
Taxable Investments
Investors interested in specific strategies for high-risk investments may still find taxable investments like mutual funds attractive. These types of investment strategies are not found in any of the 529 plans.
Non-qualified Distributions
The 529 plan can be used for schooling other than college. A non-qualified distribution does change the benefits of a 529 plan as opposed to mutual funds.
The majority of families are not interested in using high-risk investments to pay for college. Most families are also not concerned about putting away too much money for college.
The best option for most American families is a 529 plan.
How Much You Should Save for Your Child’s College
If parents begin saving from birth, approximately 0.3 percent of the college goal should be put away each month. Roughly $25 to $35 per month should be set aside each month for every $10,000 in college expenses. The one-third rule states most people do not pay for a large expense all at once. The costs are spread out over time through a combination of income and savings.
One-third of college expenses generally come from current income, another from savings, and the final third from a loan in the future. The one-third rule simply offers a three-way split.
Some parents are able to save more for college and borrow less. Others are unable to save as much and either send their children to a more affordable college or take out a larger loan.
The average family is able to save approximately one-third of the expense for college. Some families are only capable of saving approximately 10 percent of college costs for their children. These families do not even come close to their goals. The 3X rule focuses on the cost of college in the past.
Every 17 years, the cost of college basically triples.
The increase in costs for the average college education is equivalent to a 6.6 percent inflation rate. The cost of attending college does not increase as quickly as fees and tuition.
Public four-year colleges do not have as high an inflation rate for tuition as opposed to private, four-year colleges. In many cases, the tuition and fees include room and board for the student. Overall, the costs for private colleges are higher than for public institutions.
Is It a Good Idea to Pay Off Student Loans Early?
Student loans should be paid off as soon as possible for the following reasons.
Eliminating the Monthly Payment
Paying off student loans enables the individual to eliminate the monthly payment from their budget. The individual can then achieve other financial goals. The funds saved can be invested as opposed to paying off student loans to start building wealth for the future.
Decreasing the Debt-To-Income Ratio
The debt-to-income ratio can be lowered simply by paying off student loans. The individual will have more funds available when they decide to purchase a car or make an investment in a house.
The Tax Break is Not as Good as Many Believe
One of the biggest myths regarding student loans is they should not be paid off for the excellent tax break. Unfortunately, the tax break is not anywhere near good enough to wait to pay off student loans. A maximum of $2,500 can be deducted from the individual’s total taxable income.
In most cases, the individual will be paying a lot more in interest for the loans than they will save on taxes for the entire length of the loans due to the nominal tax break. The student is much better off paying off the loans than keeping them for the tax break.
The Potential Bankruptcy
Many people become so overwhelmed by student loans they consider solving the issue by declaring bankruptcy. Even if you declare bankruptcy, student loans must still be paid.
There are only three ways to eliminate student loans:
The Cost of Student Loans
Even if the individual is able to take advantage of the tax breaks for student loans, there are other considerations. The student will be spending a portion of their income to pay both interest fees and make a loan payment every month.
If the student loan debts are fairly extensive, a large portion of the monthly budget may be spent making payments. Once the student loans have been paid off, there will be more money available to save for financial goals.
The student can purchase their first home much faster. The other future options include taking a vacation overseas, opening a business, or beginning an investment portfolio for the future.
Establishing a Budget
Paying off student loans eliminates a portion of the student’s debt to relieve financial concerns. Eliminating student loans from the moment of graduation will enable the student to establish an easier budget to live a better life.
Removing Financial Concerns
One of the best ways to decrease financial stress is by paying off student loans. A lot of students put their loans at the end of their plan for paying off debts. The benefits of decreasing the amount owed to pay off student loans are generally more beneficial than paying off any other type of debt. When eliminating consumer debt such as credit cards, the student should also be paying off all private student loans. It is important to note credit cards usually have a high APR and do not qualify for tax breaks.
For all of these reasons, student loans should be paid off as quickly as possible. The moment the last payment is made, the financial future of the student will substantially improve.
With so many negatives that come with student loans, preparing for your children’s college is a must!
What Happens to a 529 Plan When the Owner Dies?
When the owner of a 529 plan dies, the new account owner is determined by the plan. Certain states allow a contingent account owner to be named in the event of the initial owner’s death. In this instance, the new owner will have all of the rights of the original owner.
Other states will allow ownership of the 529 plan to be passed to the beneficiary designated by the original owner.
Does Having a 529 Plan Hurt Financial Aid?
There are several different factors that determine whether or not financial aid can be impacted by the plan, including the kind of aid the student is applying for, when withdrawals are made and who is the owner of the 529 accounts. In most circumstances, the plan is beneficial because the impact regarding the financial aid received is minimal.
There are steps that can be taken to increase eligibility for students requiring financial aid. Federal financial aid based on need is available at all schools. The student must complete the FAFSA application to qualify for aid. This information is used by the schools to calculate the EFC (expected family contribution).
There are fewer than 200 colleges currently using any additional forms for the calculation of eligibility referred to as the CSS Profile. Every form counts the assets of the family differently.
A good example is a 529 plan owned by a grandparent. Although the plan is usually included in the CSS Profile, the asset is not reported when filling out the FAFSA. According to the FAFSA, the value of the plan, when owned by a parent or dependent student, is considered a parental asset.
Depending on the age of the parents, approximately the first $20,000 is considered an asset protection allowance. The aid package for the student will be decreased for all parental assets after that by a maximum of 5.64 percent of the value of the assets.
If the asset protection allowance is exceeded by the 529 accounts of the parents by $10,000, the financial aid for the student can be decreased by $564. Despite this small loss, the tax-free benefits of the 529 account generally outweigh the loss.
Custodial Accounts And Student Aid
Other assets owned by the student are treated less favorably. A UTMA or UGMA custodial account is considered a student asset. Financial aid will be decreased by 20 percent of the package value. In this instance, a student asset of $10,000 will decrease financial aid by $2,000.
All capital gains, dividends, and interest from the assets of the student must be reported when the student files income tax and is reported to FAFSA. The assessment for untaxed income is calculated at 50 percent for the EFC. When the student is earning funds through a 529 plan they own, the earnings do not have to be reported to FAGSA, so they have absolutely no effect on financial aid.
Can Grandparents Open A 529?
Yes, there are two different ways for a grandparent to make a contribution to a 529 plan. The first is to open a 529 plan and retain control as the owner. The second is contributing funds to an existing account.
In many instances, the parents of the student have already opened an account and given permission for others to make contributions. Prior to determining which is the right option, financial aid, tax benefits, and who controls the 529 accounts should be considered,
Can Both Parents Contribute To A 529?
Yes, both parents can make contributions. This can be accomplished by one of the parents opening an account or establishing multiple 529 plans for the child. If more than one person, such as grandparents or relatives, wants to contribute to the student’s education, separate accounts can be set up, or contributions can be made to the same 529 plan.
How Much You Should Put In A 529 Plan
Due to the accumulation of funds, as time passes, a much lower contribution is necessary per month with a 529 plan. The recommended contributions per month for a child born in 2017 at a private university are approximately $325 per month, an out-of-state public college is about $260, and an in-state public college is around $165.
The recommended monthly contribution is based on the year the child was born and the type of college the child is expected to attend in the future. The figures are determined according to the college rate of inflation during the past.
If the parents are planning to save funds through either a taxed investment account or a traditional savings account, the above figures will need to be adjusted. Let’s use the average interest rate for a traditional savings account, which is 0.06 percent APY (annual percentage yield).
The monthly contributions would change, requiring 18 years to pay one-third of the cost for an in-state public college, about $500 for an out-of-state college, and about $600 for private universities. The family would have to save almost twice as much as opposed to opening a 529 plan to pay college costs.
The returns are better for a taxed investment account. The average return is seven percent. The drawback is this type of account does not offer tax exemptions for gains and dividends provided by a 529 plan. Most average families will have an easier time saving for the college education of their children by opening a 529 plan. The final determination must be made by each family.
Where Do I Sign Up For A 529 Plan?
The website Savingforcollege.com has put together a comprehensive and thorough list of state 529 plans. Simply click on your state to see the available enrollment options available to you.
Visit the 529 plan option list here.
Wrapping It All Up
If you plan on helping your kids pay for their college expenses, time and compound interest is your best friend. Starting a 529 plan for them is an awesome gift that will help them get a head start in adulthood – without the burden of massive student loans.