About the only thing more expensive than sending your kid to college these days is not sending your kid to college. Seriously though, the cost of higher education has steadily been drifting out of the reach of the average American for years.
As a result, more young people are graduating from universities in debt than at any other time in the history of our nation. In response to this concern, 529 college savings plans were created to help parents prepare for the costs associated with higher education using tax-free earnings and withdrawals.
So, what is a 529 plan? Let’s take look.
What is a 529 Plan?
Operating much like Roth Individual Retirement Accounts, 529 college savings plans permit the after tax investment of your dollars in mutual funds, exchange traded funds and other investments of these types. The funds accrued by these investments accumulate on a tax deferred basis and can be used tax free if applied to costs associated with qualified higher education costs.
It’s important to note however, monies diverted into 529 plans cannot be used as federal income tax deductions. On the other hand, many states do consider contributions to 529 plans deductible from state tax liability.
Either way, this can give the 529 approach a decided advantage over typical savings accounts and investment accounts. What’s more, a 529 plan can also be employed as a tool for estate planning, because some of the money can be seen as a gift to the future college student. This amount can be as much as $17k per donor, per student, for tax year 2023. However, there is no upper limit as to how much can be contributed on an annual basis—until you hit the lifetime estate tax ceiling, which stands at $12.92m for the 2023 tax year.
With that said, some states do impose an overall ceiling on contributions, which ranges from $235k to $550k, depending upon the state. The amount is calculated based upon the cost of attending an expensive school with textbooks, room and board figured into the equation.
What is a Qualified Education Expense?
Given the tax free status applies only to qualified education expenses, it’s important to understand what those are considered to be. Further, withdrawals from the plan must be made in the same tax year as they are used for school. This is true even if you’re pulling money out at the end of December to cover tuition costs you’ll incur in the first week of January.
The IRS considers college tuition and fees, books and materials, room and board (for students enrolled at least half-time) to be qualified expenses. Other expenses fitting into this category include computers and related equipment, internet access, and equipment for special needs students.
Additional qualified expenses can include funds used to pay for K-12 tuition expenses, as well as student loan payments. However, the ceiling on these spends is $10k annually for K-12 tuition and $10k total toward student loans.
Do 529 Plans Affect Financial Aid Eligibility?
By and large, the effect of 529 money on a student’s financial aid eligibility is slight. This is particularly true when a 529 is compared to other types of savings accounts. Favorable treatment is afforded 529 dollars on the Free Application for Federal Student Aid (FAFSA). Moreover, 529 distributions don’t come into play when aid eligibility determinations are made—even when the funds come from grandparents or other family members.
What Happens if the Money Isn’t Used?
Kids sometimes opt for different educational options. In such instances, you’ll be taxed on withdrawals of funds and incur penalties that must be paid if the money isn’t used to further the beneficiary’s education in the prescribed manner. However, this is not the case if a disability impairs the intended beneficiary’s ability to go to school. The liabilities will also be waived if the kid goes to one of the U.S. Military Academies or gets a tax-free scholarship.
There may sometimes be monies left over after defraying a child’s educational expenses. In such instances, you can change the beneficiary, keep the money in the account to cover grad school expenses, or designate yourself as beneficiary and use the money to go to school.
The money can also be rolled into a 529 ABLE account for people with disabilities. As mentioned above, up to $10k of the money can also be used to defray annual tuition expenses for K-12 students. And, up to $10K in student loans can be paid using unused 529 funds. Moreover, starting in 2024, unused 529 dollars can be rolled over into a Roth IRA, if it has been open for 15 years or more.
Now, with all of that said, the tax and fee liability will apply only to the earnings the account returns. The principal amounts are taxed when they are deposited, so those won’t be subject to the penalties.
How Safe is the Money?
As investment bankers are required to tell would-be investors, every investment entails risk. Dollars contributed to 529 plans that are invested in the stock market or publicly traded bonds are subject to the effects of market volatility. However, some 529 plans place funds in FDIC insured accounts, or lower risk investments. Remember though, risk and reward typically go hand in hand. The riskier the investment, the higher the potential for returns may be—and vice versa.
In Summary
A 529 plan can be a useful tool. Contributions accumulate gains on a tax-free basis. And, they can be spent for qualifying educational purposes without incurring taxes. Again though, the nature of these plans varies from state to state, so it’s important to find out how they work in the state in which you plan to take this approach to fund an education.
