Are you a parent feeling like you’re scaling Mount Everest when it comes to saving for your child’s college education? Fear not, because just like a skilled mountain climber, you too can conquer this daunting task with the right tools and strategy.
You’re not alone if you’ve heard of 529 plans, for college savings but are unsure of what it implies. By the time you finish reading this article – you will fully understand what a 529 plan is, whether and how it may benefit you, and how to begin saving for college.
Take for instance the case of the Reed family. Like many parents, they were overwhelmed with the thought of funding their daughter’s college education until they discovered the benefits of 529 plans. If you’re wondering what a 529 plan is and how it can help you climb the mountain of college expenses, keep reading!
What is this 529 thing I keep referring to anyway? The name “529” college education savings plan comes from the corresponding Internal Revenue Code section, section 529. It is a tax-favored investment account to help you save and pay for college.
Most importantly I want to thank College Financial Aid expert Mark Kantrowitz for his invaluable input in reviewing and updating information in the article (current as of May 2023)
TEST YOUR 529 PLAN KNOWLEDGE
Related Reading:
- Florida Prepaid vs 529 Plan? Which Is Better For You?
- 27 Answers to Your Most Important 529 Plan Questions
- The Florida Prepaid College Plan – What You Need To Know
What is a 529 Plan?
We asked an expert to help explain what a 529 plan is, and how to best save for college. As author Mark Kantrowitz, formerly with savingforcollege.com puts it:
are specialized accounts used to pay for college (and, in some cases, private elementary and secondary schools). They come with tax and financial aid advantages.
Mark Kantrowitz
529 plans are a tax-advantaged college education savings plan and investment plan designed to help you pay for some private primary and secondary school tuition, and further education costs.
- Tuition, fees, books, computers, and room & board are all included in “higher education costs.”
- However, they exclude things like transportation and health insurance, for example.
Although a 529 has become one of the go-to savings programs for college expenses, there are some pros and cons to the program that you should be aware of first. But before we get into those – let’s first learn a little bit about the basics of why we need to save for college in the first place.
Mr. Kantrowitz summarizes saving for college as follows:
- Contributions to a 529 plan, prepaid tuition plan, Coverdell education savings account and Roth IRA are made with after-tax dollars, earnings accumulate on a tax-deferred basis and distributions are tax-free if used for qualified expenses.
- 529 plans can be used to pay for qualified higher education expenses, up to $10,000 per year in K-12 tuition, and up to $10,000 per borrower (lifetime limit) in student loan payments.
- Recently, up to $35,000 can be transferred from a 529 plan to a Roth IRA. Coverdell education savings accounts can be used for a broader set of K-12 expenses.
- Prepaid tuition plans are often limited to tuition and fees, although some may be used for room and board.
- About two thirds of the states offer a state income tax deduction or tax credit based on contributions to the the state’s 529 plan.
- Non-qualified distributions are subject to income tax on the earnings portion of the distribution, plus a 10% tax penalty.
- Contributions to a 529 plan are eligible for superfunding, also known as 5-year gift tax averaging.
The Current And Growing Cost of College
What is the “cost of attendance” (COA) of attending college first? Generally, colleges include the following expenses in their COA:
- tuition and fees
- room and board
- books and supplies
- transportation and personal expenses
Why is it important to first look at the cost of college today? Because of how expensive it is to get an education.
- For example – 40 years ago, did you know how much a year of college would cost you?
- In 1963, the annual cost of tuition at a 4-year public college was $243, which is $2,207 when adjusted for inflation. I’m sure you know where this is going…
Let’s start with the least expensive, a local two-year Community College.
Community College:
- For public community colleges, the average tuition is approximately $4,996 per year for in-state students and $8,717 for out-of-state students (2022).
- The least inexpensive state for community college tuition is Mississippi, with an average tuition of $3,443. The most expensive state for community college tuition is Pennsylvania, with an average tuition of $14,520.
So, what have we learned thirty seconds into this article? First, the least expensive Community College now costs 50% more than a four-year college program used to cost…
So let’s look at a comparable degree from a four-year public college.
- The average cost of attendance for a student living on campus at a public 4-year in-state institution is $25,487 per year or $101,948 over four years.
- Out-of-state students pay $43,161 per year or $172,644 over 4 years
- Private University students pay $53,217 per year or $212,868 over four years.
- While four years is the traditional period to earn a bachelor’s degree, just 39% of students graduate within four years.
Boy, college has gotten even more expensive than I thought. Is it even worth it to go to college anymore? Is it necessary? You aren’t alone in wondering that.
Pros & Cons of Going to College:
Click each tab to read about the pros and cons of going to college
Then use the below calculator to see the “value” of going to college.
- Those with a college education make more money, statistically.
- A college education is a way out of poverty.
- College degrees are required for more and more jobs
- In college, you tend to mature. Network and develop friends.
- You can learn more about various cultures, philosophies, and individuals at college.
- Student loans and college costs are at all-time highs.
- Some major tech companies no longer demand college degrees from their employees.
- A university education does not guarantee a better or higher-paying job.
- Not all well-paying positions demand a college degree.
- Many college students fail to ever complete their degrees.
The value of a college education calculator
Despite the cons and expenses of a college education – getting a diploma is still mostly worth it in the long run, according to “The College Payoff,” a report from the Georgetown University Center on Education and the Workforce. The study is clear – a college degree is key to economic opportunity, leading to substantially higher earnings for those with a college degree vs. those without.
Saving For College: The Basics
Great, so you have terrified me so far. College is becoming impossibly expensive – but if I want my kids to earn more, it is a necessary evil. So what do I do?
Dave Ramseys 7 Baby Steps
You have every right to be concerned about the cost. But the fact that you have come this far and are looking for a solution – shows you are a caring parent who wants the best for your child. And I will be here to walk you through the best options.
I have two sons myself, so I know the difficulty. But as a former financial planner – it was a bit easier for me to know how to navigate through the college savings maze. So let me help walk you through it as well.
Wondering how much to save for college, or how much to contribute to a 529 plan?
Saving For College – 529 Calculator
APY Calculator
Start Early
That is the best and simplest advice anyone can give. Use the power of compounding interest to your advantage. Start early and keep saving consistently. We all know having a baby is incredibly expensive and strains most budgets. But waiting to start saving for college is equally painful and more expensive.
Savings now vs savings later calculator
Invest Smart
I am not talking about picking the best stock for the next 18 years to pay for your child’s college. What I mean by that is choosing the right way to save for college can drastically impact how much you will eventually have available to pay for education.
It is no different than the way you are saving for retirement. You can save into a taxable account, but you know that better tax-deferred accounts are available, such as a 401(k) plan. Or even better is a tax-free savings plan such as a Roth IRA. College savings is no different.
You can save into a taxable account. Or, as you guessed, you can save into a tax-free account such as a 529 college savings plan. Consider the difference in how much you would have accumulated after taxes:
Crowd Funding
Who can contribute to a 529 plan? One of the greatest advantages of a 529 college savings plan is that anyone can contribute to the account. In addition, family members such as grandparents can gift into the account if they choose to, on birthdays, holidays, whenever.
So as you can see – the tax advantages allow you to keep substantially more of your savings by using a 529 plan. So let’s look at what a 529 can do for you.
How Do 529 Plans Work?
Since most people are familiar with a 401(k), think of a 529 college savings plan as a Roth 401(k), but for college. It is probably the simplest way to explain how does a 529 plan work.
Just like a Roth 401k, a 529 plan
- Are 529 withdrawals taxable? If it is used for its intended purpose, college education, you can withdraw your investment income tax-free.
- Just like a 401k is run by a financial institution and established by your employer – a 529 is invested through financial institutions and sponsored by states.
- The account owner chooses how to invest the savings within the account.
- You will be limited to investment choices that are available within the plan. The states, like your employer, determine which investment options will be available to you. In 529 plans, it is very common for target date funds to be offered – which get less and less aggressive as college approaches.
- Familiar names that manage 401ks also manage many 529 plans – Fidelity, Vanguard, and Schwab
One major update in 2023 is the SECURE 2.0 Act. Beginning in 2024 you can rollover an unused 529 to Roth IRA (up to $35,000)
Benefits & Tax Advantages Of a 529 Plan
Benefits of a 529 college savings plan calculator
Are 529 Plans Worth It?
The tax advantages of a 529 plan are the primary benefit of using the plan to save for college. A 529 plan is similar to a Roth because earnings are tax-free and won’t count toward your income when used for authorized educational expenses.
However, think about what happens if you were to use your Roth IRA to go out and buy a car before you retire. Distributed 529 plan gains (not contributions) for purposes other than allowable educational expenses are taxable income and come with a 10% tax penalty.
So while there are ways to get around it, the exclusions may not pertain to you and your situation.
Just like a Roth contribution, there is no federal tax deduction for contributions to a 529 plan. Still, unlike a Roth, many states WILL permit state tax deductions for at least some or all 529 payments to their own 529 plans. A few states will even permit deductions for contributions to any plan. But keep in mind that a few don’t provide any deductions. Below is a list.
Blackrock also made an excellent infographic with the maximum amount of tax deduction for 529 contributions in each state.
529 Contribution Limits – How Much Can You put In a 529 Per Year?
Unlike retirement savings accounts, anyone can contribute to anyone else’s 529 college savings plan. Friends and family can contribute to a plan that belongs to someone else; you don’t have to be the owner to contribute. But just like retirement plans, there are limits to how much you can save in a tax-advantaged plan.
Click each tab below:
- 529 plans do not have annual contribution limits. On the other hand, contributions to a 529 plan are considered completed gifts for federal tax purposes. In 2023, a donor can give up to $17,000 per beneficiary without paying a gift tax.
- Contributions over $17,000 must be reported on IRS Form 709 and may count against the taxpayer’s lifetime estate and gift tax exemption amount ($12.9 million in 2023).
- You can also make a larger tax-free contribution to a 529 plan if the contribution is treated as if it were spread out evenly over five years.
- For example, an $85,000 lump sum contribution to a 529 plan can be used as if it were $17,000 per year, as long as no other gifts are given to the same beneficiary over the next five years.
- This 5-year gift-tax averaging is a strategy that some grandparents use to plan their estates.
- Each state sets a total limit on how much you can put into a 529 plan.
- The limits are roughly based on how much it costs in that state to go to a four-year college and graduate school.
- Once you have reached the 529 plan state’s limit, no more contributions can be made to a 529 plan run by that state.
- Families may be able to contribute more than a state’s total limit by putting money into a 529 plan in another state. IRS rules don’t say that a beneficiary can’t have accounts in different states that add up to more than a state’s limit.
One unknown tax quirk that I have seen some people take advantage of:
People have created a 529 in their state, offering a tax deduction for the year they will be paying for college. They have contributed, taken the state tax credit that year, then immediately paid for their tuition. Indirectly they paid tuition but received a state tax break – speak to your tax advisor before attempting this!! This is only advantageous if you qualify for the state deduction.
Related Reading:
The Dave Ramsey 7 Baby Steps Program
The Best Personal Finance Books For College Students
529 Plan Restrictions And Workarounds
Remember earlier in the article I mentioned that there are some 529 plan restrictions? And I also briefly hinted that there might be some workarounds? Let’s take a look at a few of each now.
What Expenses Qualify For 529?
The 529 Plan MUST be Used For ‘Qualified Higher Education Expenses.’
The first and biggest 529 plan restriction is that you must use the proceeds for “qualified higher education expenses” The requirement for approved education expenses is a significant restriction. So 529 plan withdrawals need to be used for the following:
– Certain room and board
– Books
– Supplies and equipment required for enrollment or attendance at an eligible educational institution
– Computers and equipment, computer software, internet access, and related services
– Certain other expenses may also qualify if your beneficiary is a special-needs student.
The IRS explains it further.
Can 529 be used for rent?
While 529 plans can be used for a variety of college expenses, they may be used for rent. According to financial aid expert Mark Kantrowitz – “529 plans can be used to pay for rent, up to the allowance set by the college.” See relevant excerpt from 26 USC 529(e)(3)
What happens if your child doesn’t attend college? What happens to 529 if not used?
Your money is not lost if your child decides not to go to college. What can I do with leftover 529 money?
The first option is to transfer the 529 plan to another child.
Your second option is to transfer it to you or your spouse. There are rumors of people traveling internationally to take “classes” and fund them with their 529 plan.
A third option is to transfer the account to another family member, such as a niece or a nephew. Speak with your tax advisor for creative ways to transfer the account.
A final option is to withdraw the savings from the 529 plan fully. As I mentioned, the account would first be subject to a 10% penalty for not using it for its intended purposes. Secondly, you would now owe income tax on the earnings since you have not yet paid taxes on them.
What happens if your child receives a scholarship, so you didn’t need/use the 529 savings?
If your child receives a scholarship, first off, congratulations!! The good news is that you can still use the 529 plan for permitted expenses above the scholarship. There is some good news for the amount of the scholarship as well.
For example, let’s say your child earned a $10,000 scholarship. You are allowed to withdraw $10,000 from the 529 plan and NOT pay a 10% penalty on that $10,000. This helps you avoid a $1,000 penalty.
The slight downside to the great news of the scholarship? The $10,000 you withdraw WILL be taxable now, at least the part attributable to earnings on the account.
How Do I report 529 plan withdrawals on my federal tax return? Saving for college did an excellent write-up on this that can explain it better than I ever could.
Your Investment Options Are Limited By Your State and Plan Administrator
Do you want to invest in a hot new stock your friend told you about? I can’t do it in a 529. Want to invest in your favorite mutual fund or ETF? You probably can’t do that in your 529 plan either.
Just like a 401(k) plan, you have limited to the investments your plan permits. Even worse, you are only permitted to change your investments a few times per year – typically twice a year.
Investment and plan fees, comparable to 401k fees, will also apply to you.
You don’t like the plan you chose? Sure, you can make a change and transfer to another state-sponsored plan. But you are restricted to how often you can make that change. Typically – you can change your plan sponsor once per year.
Does a 529 Affect Financial Aid?
A 529 is treated differently on FAFSA (Financial Aid) applications depending on who owns it. Here are the basics when it comes to a 529 plan and the impact it will have on financial aid:
- If a direct family member owns the 529 plan, the savings will count towards the family’s expected contribution to the cost of college.
- Money in a 529 is an available asset for the owner, which would affect the expected family contribution if that owner is a parent. BUT, I look at it this way. You won’t need much aid if you have a sizable 529 saved. So it won’t matter.
- If it’s a third-party owner, it counts as untaxed student income, so it counts more heavily against the applicant.
- If this is still a concern for you, many people will be the’ owners’ of the 529 accounts instead of the grandparents. Why would you choose to do this? Because a 529 owned by the grandparents is not considered a family asset. The downside is that the 529 distribution would count as income to the student, creating another financial aid headache.
- The ideal strategic mix is to use a parent-owned 529 in the first few years of college, so the account dwindles. Then the final year or two is paid for with a grandparent owned 529.
I do want to note that the somewhat recently passed FAFSA Simplification Act of 2020 will eliminate the “income paid on behalf/gift” income reporting of students beginning in the school year of 2024/25.
what to do if you miss the FAFSA deadline.
FAFSA On The Web Has Encountered An Error
As a result, funds paid out of 529s owned by someone other than the student or parents no longer impact the FAFSA starting with the 2024-2025 school year.
Mark Kantrowitz, author of How to Appeal for More College Financial Aid, summarizes aid as follows:
- Money in a 529 plan, prepaid tuition plan and Coverdell education savings account is reported as a parent asset on the FAFSA, even if it is a custodial account owned by the student.
- Accounts that are owned by someone other than the student or parent, such as a grandparent, are not reported as assets on the FAFSA, but distributions count as untaxed income to the student.
- The latter may change with FAFSA simplification starting in 2024-25.
Next Steps: What Should You Do To Save For Your Child’s College Education?
- There is no timeframe or limit to when you can begin to open and save in a 529 college savings plan for your child. But we know that the sooner you begin to save, the better off you will be.
- You can start a 529 plan anytime and make whatever contributions you want. You can save on a regular or sporadic basis.
- Is 529 pretax savings? YES – you save pretax dollars, and if used for higher education – it comes out tax free.
What Are the Benefits of Choosing a 529 Plan for College Savings?
When it comes to planning for your child’s future education, a 529 plan is one of the best college savings options available. These plans offer numerous benefits, such as tax advantages, flexibility in investment choices, and the ability to use the funds for qualified education expenses. With a 529 plan, you can financially prepare for your child’s college education with peace of mind.
Which 529 Plan is Best?
I am no longer a licensed financial planner, so I am not advising on which 529 plan would be best for you. Instead, I can summarize some of the most respected reviewers of 529 plans, along with my experience as a parent, a financial coach, and a former financial planner. In my opinion, these are currently the best 529 plans overall, in alphabetical order: My Top are:
- California ScholarShare 529
- Florida 529 Savings Plan
- Illinois BrightStart 529 Plans
- Indiana College Choice 529
- Michigan Education Savings Program
- New York 529 Savings Plan
- Ohio College Advantage
- Utah My 529
- West Virginia Smart 529
- Wisconsin 529 Edvest.
In my opinion only, not advice – but if I were looking to start a 529 plan for my newborn today and did not have to factor in state taxes – I would personally look at two plans. New York And Ohio.
- New York’s plan has low fees, excellent Vanguard funds, and is open to residents of any state.
- Ohio’s plan has few weaknesses and is an overall solid program from top to bottom.
Sources: Bankrate, savingforcollege, morningstar, clarkhoward, my experience
Related Reading:
- Florida Prepaid vs 529 Plan? Which Is Better For You?
- 27 Answers to Your Most Important 529 Plan Questions
- The Best Financial Books For Young Adults To Read in 2023
- Complete Guide – Everything You Need to Know About Life Insurance 2023
- The Florida Prepaid College Plan – What You Need To Know
The Answers To Your 529 Plan Questions – FAQ
- What is a 529 Plan or Account?
- How does a 529 plan work?
- What can 529 funds be used for?
- Are 529 contributions tax deductible? Are 529 contributions pretax?
- Are 529 plans worth it?
- How to open a 529 plan and set it up?
- Which 529 plan is the best?
- Can I have more than one 529 plan?
- Who can contribute to a 529 plan?
- How much to contribute to 529 plan?
- How to use 529 funds?
- Is a 529 plan worth it?
- What are qualified 529 expenses? What can a 529 be used for?
- Who maintains control over the 529 plan?
- What happens to 529 plan when a child turns 21? What happens to 529 plan when a child turns 18?
- Can a 529 be used for high school? Can you use a 529 for private school?
- Can 529 be used for rent?
- Does a 529 earn interest?
- Can you use a 529 to pay student loans?
- How to document 529 expenses?
- How to report 529 distributions on a tax return?
- Can 529 be used for graduate school?
- What happens to 529 if not used?
READ: 27 Answers to Your Most Important 529 Plan Questions
Different Types of Student Loans: What You Need to Know Before You Borrow
Still, have questions and want more information? Here are some excellent other resources:
- 529 Search and Comparison Tool
- FINRA’s Saving for College website.
- FINRA has developed a tool to help you compare how plan fees and expenses can reduce returns.
- SEC’s Investor Bulletin: How Fees and Expenses Affect Your Investment Portfolio.
- U.S. Department of Education’s Federal Student Aid website.
