Paying for College (Part 2): Saving for College with a 529 Plan
529 plans are the bedrock of college savings strategies – a financially smart way to pay for education costs. They offer a tax-advantaged way to save for college and, depending on the state you live in, often have additional tax benefits.
One caveat: 529s come with a few limitations and drawbacks. The plans are exposed to market risk, assess penalties for non-education-related withdrawals and overfunding, and can affect the amount of financial aid a student is eligible to receive.
The significant advantages they offer, however, can make them a savvy investment for parent and child alike when selected and administered properly. Even wealthy families who could handle all college costs out of pocket can benefit from 529s, capitalizing on not just the tax and financial advantages they provide but also their estate-planning and gifting capabilities.
“A 529 plan lets you have your cake and eat it too,” said Mark Kantrowitz, author of two books on college financing strategies and the former longtime publisher of Savingforcollege.com, in remarks to Altair. “Contributions to a 529 plan are immediately removed from the donor’s estate, yet the account owner (who can be the donor) retains control over the 529 plan.”
This article provides an overview of 529 plans and guidance on how to navigate the various steps associated with establishing and overseeing an account for your child’s education expenses. We have recommended them for many client families and can assist personally with further specifics about a 529.
529s – The Basics
Accounts in 529 college savings plans are used to accumulate a pool of assets which are invested in the markets and grow tax-deferred until withdrawn for education expenses as needed. Distributions are tax-free if used to pay for qualified education expenses. Created as a vehicle for postsecondary education costs, the 529 has since been expanded in many states to cover K-12 education and apprenticeship programs. While the name is derived from Section 529 of the federal tax code, the plans are administered by the 50 states and the District of Columbia.
Almost every state has its own 529 program. Their investments and tax benefits differ. You can pick any state’s 529 program regardless of state of residence. The two major types are education savings plans and prepaid tuition plans. An account owner and student beneficiary must be designated, but anyone can contribute. Each state has a limit on the maximum account balance (e.g., $450,000 for Illinois plans).
Contributions are in after-tax dollars. Some states offer income tax deductions on contributions. The account grows tax-deferred. Distributions are tax-free if used for qualified education expenses.
You can put in as much as $17,000 per year ($34,000 if married) without triggering gift tax consequences, or accelerate up to five years of contributions (known as “superfunding” – see Contributions section below for more). Unused funds can be transferred to another relative.
Pros and Cons
The potential pluses will likely outweigh the minuses for most people considering a 529 plan, but prospective accountholders should be aware in advance of its limitations.
PROS
- Take advantage of market growth to subsidize education costs
- Significant tax advantages; investment returns are not taxed as long as the money is used for education
- Numerous investment options
- No restrictions on who can contribute
- Ability to change beneficiary
- Good way to remove assets out of estate while retaining asset control (student cannot use account without owner)
- Low fee options
- Flexibility – you can invest in any state’s 529 program and funds can be used at more than 6,000 schools
- Peace of mind derived from designating and funding a separate account earmarked for large education expenses
CONS
- Non-qualified withdrawals subject to tax on earnings portion and 10% penalty on withdrawal amount
- Exposure to market risk
- Impacts financial aid eligibility
- State income tax deductions could be recaptured
Qualified vs. Non-Qualified Expenses
Most major education expenses – but not all – are considered qualified for 529 plan purposes. Knowing them ahead of time can help avoid tax-related pitfalls.
QUALIFIED
- Tuition and Fees
- Up to full amount of college tuition and required fees
- Includes technical and vocational schools
- Books and Supplies
- For college expenses only
- Computers and Internet Access
- For college expenses only
- Room and Board
- If enrolled at least half-time
- Includes both on- and off-campus housing costs incurred during the academic period
- Prepaid tuition plans cannot be used for room and board
- Special Needs Equipment
- For college expenses only
NON-QUALIFIED
- Transportation and Travel Costs
- Airfare and gas used to go to and from campus
- Health Insurance
- Unless part of tuition or required for enrollment
- College Application and Testing Fees
- Extracurricular Activity Fees
- Student Loans
- You may not use 529 assets to pay student loans without incurring 10% penalty on the distribution amount + tax on earnings portion of distribution
- Non-Qualified Rollovers
- Rolling over a 529 plan more than once per 12-month period per beneficiary
Withdrawals and Penalties
Removing money from a 529 plan is more complicated than putting money into one. Heeding the rules on withdrawals, however, will ensure tax-free distributions, no penalties, and the full retention of state income tax breaks associated with it.
Distributions are tax-free if limited to qualified education expenses as long as the expenses are paid in the same tax year as the distribution. You cannot use a qualified expense to justify more than one tax break, however, such as a tax-free distribution from both a 529 plan and the American Opportunity Tax Credit.
Other points to remember:
- Only the earnings portion is subject to income tax and 10% penalty
- The contribution portion is never taxed or penalized
- Distributions payable to the beneficiary are taxed at the beneficiary’s rate and distributions payable to the parents are taxed at the parents’ rate
- State income tax deductions may be recaptured
- Look out for states that impose additional penalty (California imposes 2.5% penalty on earnings portion)
- Some exceptions to withdrawal penalty
- Beneficiary dies or becomes disabled
- Beneficiary receives tax-free scholarship
- Beneficiary attends United States Military Academy (West Point)
Impact on Financial Aid
Having a 529 plan can reduce the amount of need-based financial aid a student is eligible for. The impact is limited, however. The amount varies depending on who owns the account.
Parents and students: Money in a 529 account owned by the parents or a dependent student is considered as parental assets on the FAFSA (Free Application for Federal Student Aid), the form that must be submitted in order to obtain financial aid for college or graduate school. A maximum of 5.64% of parental assets is counted in determining the Student Aid Index (SAI), formerly called the Expected Family Contribution, on the FAFSA. That would jump to 20% for student assets – when the student is not a dependent for tax purposes. The higher the SAI, the less the financial aid.
529 plan distributions get favorable treatment on the FAFSA. Qualified distributions from either a student-owned or a parent-owned account are not included in the base-year income that would reduce aid eligibility – as long as they are used to pay the current year’s college expenses.
Grandparents: Assets in a 529 plan owned by a grandparent, another relative or anyone else have no effect on the student’s SAI. Under the newly simplified FAFSA taking effect for the 2024-25 school year and beyond, qualified 529 plan distributions from accounts by grandparents or anyone else are not reported as income on the FAFSA.
Trusts: Ownership by trusts of 529 plans is generally recommended only in rare circumstances where added control is required. 529s already avoid probate (the successor owner and beneficiary are already designated), and the trust does not “hide” the 529 plan for financial aid eligibility purposes.
Grandparent-Owned Plans
Grandparents who want to assist with grandchild’s college costs have options. They can contribute to a parent-owned 529 plan, become account owner for their own plan with the grandchild as the beneficiary, or establish a custodian account with the child as owner and beneficiary.
Unlike a parent-owned plan, as mentioned above, a grandparent-owned plan carries the advantage of having no impact on the student’s financial aid eligibility.
Picking a Plan
Your home state’s 529 plan is a good place to start your search but you should not stop there. Some other states’ plans may offer lower fees, better tax breaks, more investment choices, or a better state tax situation for funding a private school education (see the Schools Besides College section below for more). In making your selection, you will likely want to look at the combined impact of fees and state income tax breaks.
Consider these factors when selecting a plan:
- Investment Options
- Ensure the plan you choose offers quality mutual fund or index fund to maximize potential investment returns
- Are the investment options consistent with your risk appetite?
- Fees
- What types of fees does the plan charge? Is there an annual fee?
- Account opening fee?
- Are there high fees on the investment options?
- State Tax Benefits
- Does your state’s plan offer any tax benefits on contributions?
- Ease of Administration
- How responsive is the plan?
- How is the customer service?
- Are there minimum contribution amounts?
For a good overview by state, see the list in the 529 plan guide compiled by The College Investor. Morningstar also has created a U.S. map linking to summaries of all states’ 529 plans.
Contributions
529 plans have no contribution limits, but contributions are subject to federal gifting laws. In 2024, contributions of up to $18,000 per donor per beneficiary ($36,000 for a married couple) are allowed without those funds counting against the lifetime gift tax exemption amount.
- Multiple children
- Consider contributing more to the oldest child’s 529 account and rolling over unused funds to a younger sibling.
- Only child
- Adjust contributions as the future student develops more clarity around possible schools and programs.
- Overfunding
- It is recommended to avoid overfunding 529 plans since non-qualified withdrawals are subject to 10% penalty and taxation on the earnings portion. To help avoid this, coordinate funding plans with other relatives who wish to contribute.
- If you overfunded, consider rolling account over to other relatives.
- Superfunding
- The strategy of using five-year gift tax averaging may appeal to those with significant assets, reducing future estate taxes through gifting while also jumpstarting a college savings account. This allows an individual to make a lump-sum contribution of up to five times the annual gift tax exclusion and have it treated as if it occurred over five years. That is $90,000 for an individual contributor in 2024, or $180,000 for a married couple. Consider superfunding a 529 account if you have a high-income year. If you die before the end of the five years, part of the contribution may be included in your estate.
Other Options for Unused Assets
You can use leftover 529 funds for any eligible institution besides college, including vocational school. Personal interest classes are another alternative, when connected to student aid programs administered by the U.S. Department of Education.
Originally targeting college costs, 529 plans now also can be used to pay for $10,000 in tuition expenses at elementary or secondary public, private or parochial schools – although state taxes may apply.
529 plans allow you to change the beneficiary to one of your beneficiary’s eligible relatives without tax implications or other penalties. Eligible family members include spouses, siblings, step-siblings, parents, cousins, aunts, uncles, nieces, nephews and in-laws.
If the intended new beneficiary already has a 529 plan, you may wish to consider a rollover instead. You are allowed one rollover to another 529 plan per 12-month period per beneficiary.
Withdrawing the remaining money in the account is not severe as last resorts go – you will pay a 10% penalty and tax on the earnings.
Beginning this year, in 2024, unused assets in a 529 plan may be eligible to convert to a Roth IRA for the beneficiary, subject to rules and limitations. Consult your adviser for more information.
The material shown is for informational purposes only and should not be construed as accounting, legal, or tax advice. Although we made efforts to verify the accuracy of the information, Altair Advisers cannot guarantee its accuracy. Please see Altair Advisers’ Form ADV Part 2A and Form CRS at https://altairadvisers.com/disclosures/ for additional information about Altair Advisers’ business practices and identified conflicts.