One of the best ways to save for college is with a 529 College Savings Plan, which is named after section 529 of the Internal Revenue Code, 26 U.S.C. 529. Why should you care about a 529 plan? Because they can offer some very nice tax benefits as an incentive to save for college. Let’s take a look at 529 plans and why they are a great way to save for college.
529 College Savings Plan
Where can you open a 529 plan?
Each state has it’s own version of the 529 plan and you can choose to invest in a 529 plan from your state or from another state. However, it’s often more advantageous to invest in a 529 plan within your state of residence because many states offer tax advantages and potential scholarship opportunities. Additionally, 529 plans from your state of residence are exempt from financial aid calculations, meaning the money saved in the plan won’t prevent your eligibility for other sources of financial aid programs.
Two Types of 529 Plans – Prepaid and Savings
There are two types of 529 plans, one is a prepaid plan and the other is a savings plan.
Prepaid 529 Plan. Prepaid 529 plans allow you to buy tuition credits at today’s costs, which can be used in the future. The advantage of this is the ability to lock in your college costs before inflation and time causes them to increase. Prepaid 529 plans are administered by individual states for state run universities, or by individual colleges.
529 Savings Plan. The savings version of the 529 plan functions similar to a retirement account, but it is used for college tuition and eligible expenses. The savings plan can have different types of investments, such as Certificates of Deposit, mutual fund index funds, and ETFs. These plans offer more flexibility, but are subject to market returns, so you could potentially make or lose money. Savings 529 Plans are administered through states at times, but the actual record keeping and administrative work involved in the plans are typically handled by financial services companies or mutual fund companies.
What 529 Plans Can Be Used For
Qualified expenses for 529 plan funds include tuition, room and board, books, supplies, equipment and college related fees required to study at any vocational school, accredited college or university program in the United States. Some foreign universities also qualify. 529 savings can be used in conjunction with the GI Bill to help pay for expenses not covered by your GI Bill benefits.
You may not use money from a 529 plan to pay back student loans or student loan interest.
Tax Advantages and Benefits of 529 Plans
Many people prefer the 529 plans for college savings vehicles because of their tax advantages.
- Tax deferred growth. Money in a 529 account grows tax-deferred and can be withdrawn tax-free if used for qualified educational expenses for the beneficiary of the 529 plan. The donor (person who opens the 529 plan) remains in complete control of the fund. Most 529 plans will even allow the donor to reclaim the money for themselves if things change, although the earnings portion of non-qualified withdrawals are subject to income tax and a 10% penalty. The assets returned to the donor are also not included in the donor’s gross estate for estate tax purposes.
- Tax deductions on contributions. On a federal level, contributions to a 529 are not deductible from income tax liabilities, but most states allow state income tax deductions for all or part of 529 contributions.
- Withdrawals may not be considered taxable income. When you take distributions from your 529 plan for qualified higher education expenses, the money is exempt from federal income tax.
- Watch out for non-qualified distributions. If you take money from your 529 plan for anything other than qualified educational expenses, the distribution is subject to income taxes and an early distribution penalty of 10% on the money the plan has earned except under a few circumstances.
529 plan eligibility
Everyone is eligible for a 529 plan – there are no income or age restrictions. The opening contribution generally has a low minimum requirement, and the ongoing contribution requirements are low, as well.
Ability to transfer 529 funds to family members. Another benefit of 529 plans not commonly found in college investment vehicles is the ability to transfer the money from one beneficiary to another family member without penalty. Qualified family members may include son, daughter, step children, adopted children, foster children, siblings and step siblings, parents, step parents, nieces and nephews, aunts, uncles, in-laws, first cousins, or the spouse of any qualified family member.
Interested in learning more about 529 college savings plans? Check out these articles:
FYI – a Coverdell ESA is another type of college savings plan that offers tax advantages. Here is more information about a Coverdell Educational Savings Account (ESA), and How and Where to Open a Coverdell ESA Plan.