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Saving for College

Saving for College: 529 College Savings Plans

Key Points
  • A 529 college savings plan is a state-sponsored program that allows parents, relatives and friends to invest for a child’s (or any person’s) college education.

  • You may be able to contribute more than $14,000 a year to a 529 without being subject to gift taxes. States can have different limits on total account sizes, with most in the $300,000–$400,000 range per beneficiary, though some are even higher.

  • Earnings in a 529 college savings plan grow federally tax-deferred, which means money can compound faster because you don’t have to pay taxes on current investment income or capital gains for withdrawals used to cover qualified higher education expenses.

A 529 college savings plan is a state-sponsored program that allows parents, relatives and friends to invest for a child’s (or any person’s) college education. All states offer some type of 529 plan. However, in most cases you don’t have to live in a particular state to take advantage of its 529 plan.

You make contributions with after-tax dollars, but earnings grow tax-free, which means money can compound faster because you don’t have to pay taxes on current investment income or capital gains. Then, you can withdraw the money tax-free to pay for qualified education expenses—tuition, books, supplies, room and board—at virtually any accredited college or university in the United States (and even some foreign schools).

A 529 account belongs to you, and your child is the beneficiary. Your money is actively 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 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.

What if your child’s plans change? Or what if your child graduates, and there’s money left over in your 529 account? You can change the beneficiary on the account to another qualified family member. Don’t worry about finding a family member who needs money for college: 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.

Alternatively, you can simply withdraw the money from your account. Keep in mind, though, that you’ll be subject to federal income taxes as well as a 10% penalty for nonqualified withdrawals on any earnings.

And if your child gets a scholarship? If you chose to withdraw the money instead of changing beneficiaries, you would have to pay ordinary income taxes on any earnings above the amount you contributed (as the contributions would have been made with money that had already been taxed). You would not have to pay the 10% penalty on earnings as long as the withdrawal was less than the amount of the scholarship.1 If you withdrew more, then the 10% penalty would apply to any earnings on top of the ordinary income taxes.

529 prepaid tuition plans

If you know your child will attend a public school in your state, you can take advantage of a second kind of 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.

What 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, but they usually only pay the average in-state tuition cost. There is also a 529 plan available that was designed for a consortium of specific private schools.

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 at a brokerage or other financial institution, or directly with a state. A child 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.

The typical initial investment to open an account ranges from $500 to $2,500. Many 529 college savings plans allow you to open an account for considerably less—in many cases $25 to $50 a month—if you sign up for an automatic investing plan, with 529 contributions coming directly from your bank or brokerage account.

Ask whether your company allows you to make 529 contributions automatically as a payroll deduction—many companies have added this benefit.

Use your 529 plan to invest for growth

Although past performance is no guarantee of future returns, stocks have historically offered the best chance for money to grow over the long term—though stocks increase your chance for loss of principal compared to bonds or cash. If college is more than 10 years away for your child, consider investing in a diversified portfolio that includes stocks. Then, gradually move those funds to more conservative holdings as your child nears college age.

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.

Also, if you invest in your own state’s 529 plan or if your state is a “tax parity state,”2  you may benefit from state income tax deductions on contributions or state tax exemptions on withdrawals.

You can generally contribute up to $14,000 a year (or $28,000 for couples) without incurring the gift tax. It’s also possible to contribute a lump sum of up to $70,000 to one or more 529 college savings plans in a single year ($140,000 for couples) without incurring the gift tax—the IRS views the money as an annual $14,000 (or $28,000 for couples) gift over five years. However, if you contribute more money on behalf of the same child during those five years, you trigger the gift tax.

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

Effect on financial aid

Financial aid formulas consider 20% of the assets held in a child’s name available for college expenses. But a 529 plan is considered your asset, not your child’s—as a result, only 5.6% of the money is considered available for college expenses.

Even better is that if a grandparent (or other non-relative) owns the 529 plan, the account assets won’t factor into financial aid calculations at all. However, withdrawals in support of a grandchild will factor into his or her Free Application for Federal Student Aid (FAFSA) calculations two years after the distribution is made. (In other words, distributions made in a grandchild’s freshman year will be taken into account on the junior year FAFSA.)

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

Saving for college is a smart financial move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid with interest.  Every dollar saved is one dollar you may not have to borrow.

For more about financial aid, check out the U.S. Dept. of Education or the College Board.

Scholarships 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.

States 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, Maine, Missouri, Montana and Pennsylvania.

What you can do next

To discuss how this article might affect your investment decisions:

 

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Important Disclosures

Before investing, carefully consider the plan’s investment objectives, risks, charges and expenses. This information and more about the plan can be found in the disclosure statement or Participation Agreement available from your financial institution and should be read carefully before investing.

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