How Military Families Can Use 529 Plans to Save for their Children’s Education

529 plans can offer a powerful compound growth effect over time. When you put your money to work now while your children are young, these dollars can grow to keep up with rising costs for college education. 
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529 education plans

As a financial planner, I regularly advise military families about the best way to save for their children’s education. In almost every case, the answer is a 529 plan.

Section 529 of the Internal Revenue Code authorizes qualified tuition plans – hence the common name “529 plans” – to encourage families to save for future education costs.

Of note, this article will not address the 529 ABLE accounts for people with disabilities which can be a powerful planning tool for families.

A 529 plan is similar to a Roth IRA in that you invest after-tax contributions. Your investments grow on a tax-deferred basis (without paying capital gains taxes each year) and you can withdraw these funds tax-free, so long as you use the money to pay for qualified higher education expenses.

Daniel Kopp, CFP ®
Daniel Kopp, CFP ®, is a fee-only, fiduciary financial planner and founder of Wise Stewardship Financial Planning, which helps military service members, widows and widowers organize their financial lives by aligning their money with their deeply-held values. Kopp is also an Air Force veteran with nearly nine years of service.
  • Qualified education expenses include tuition, fees, books, and supplies for college or graduate students, as well as room and board expenses for those enrolled at least half-time. Certain apprenticeship programs also qualify.
  • Recently, qualified education expenses have been expanded to also include other expenses, such as up to $10,000 of tuition expenses annually for K-12 education (via the Tax Cuts and Jobs Act) and to pay off up to $10,000 of lifetime qualified student debt (via the SECURE Act).

529 plans can offer a powerful compound growth effect over time. When you put your money to work now while your children are young, these dollars can grow to keep up with rising costs for college education.

529 Plans and Tax Considerations

Contributions to 529 plans can be state-tax deductible up to state limits, but not federal income tax-deductible. In other words, contributions don’t change your federal income tax situation. You can use a 529 plan in any state to pay for any qualified education expenses. (i.e. Utah 529 funds can be used to pay for qualified education expenses in Florida).

If you are paying state income taxes, your first option should probably be to open a 529 account in that specific state so you can take advantage of the state tax deductibility with that state’s plan. If you aren’t paying any state income taxes right now, you can pick any 529 plan.

If the fees for that state’s plan are particularly high or if they are a bottom-ranked plan, consider doing a trustee-to-trustee transfer to move the 529 funds over later. That way, you still get the state tax deduction upfront and then lower ongoing investment costs in the other plan.

529 Plan Benefits

529 plans aren’t subject to annual contribution limits (however be aware of the IRS rules around the gift tax exclusion and how it has a special provision related “superfunding” a 529 plan)

They are subject to total maximum balance limits which vary by state (currently ranging between $235,000 and $529,000). However, there’s nothing to stop you from opening another 529 if you hit the limit on one.

529 plans also offer more flexibility for families and for their students when they begin their education than some other accounts. Unlike Coverdell (Education) ESAs, 529 funds don’t need to be distributed when the beneficiary reaches age 30. There is no minimum or maximum age at which beneficiaries must use their 529 funds.

While 529s can only have one owner and one beneficiary at any given time, the owner can change both without tax consequences, as long as they follow certain rules.

IRC Section 529(e)(2) stipulates that the beneficiary of a 529 plan account may be changed to the current beneficiary’s:

  • Spouse
  • Child, or the spouse of such child
  • Brother, sister, stepbrother, stepsister, or the spouse of any such person
  • Mother, father, the ancestor of either, or the spouse of any such person
  • Stepfather, stepmother, or the spouse of either such person
  • Nephew, niece, or the spouse of either such person
  • Aunt, Uncle, or the spouse of either such person
  • Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law, or the spouse of any such person
  • First cousin

If an individual who is not an eligible family member above becomes the 529 plan beneficiary, the IRS will consider this as a distribution of the 529 plan assets. The account owner would generally owe both ordinary income tax on earnings and a 10% penalty on the entire balance.

The ability to change beneficiaries makes 529s attractive to expecting or hopeful parents who are eager to start saving for their unborn children’s education.

Parents can create 529 accounts naming themselves as both account owner and beneficiary. Once their children are born, parents can re-designate the newborn child as the beneficiary for their future education expenses.

Do 529 Plans Impact Financial Aid and Scholarships?

Using a 529 plan to save for college has a minimal impact on financial aid eligibility compared to other savings accounts, like UGMA/UTMA accounts.

Assets held in the 529 plan are not weighted as heavily against applicants’ financial need on the Free Application for Federal Student Aid (FAFSA), and distributions are not reported as income.

What if you don’t need 529 funds?

Families commonly ask me what happens if a student doesn’t need their 529 funds.

For example, what happens if your kid doesn’t go to college or perhaps attends a service academy or gets an ROTC scholarship?

Good news – there are some options!

You can change the beneficiary as mentioned earlier. Or, you can just take the withdrawal from the 529 and forgo some of the tax benefits.

The IRS waives the 10% penalty for non-qualified withdrawals if the beneficiary receives a tax-free scholarship (ex. ROTC), a service academy appointment, or if the beneficiary dies or becomes disabled.

However, your withdrawals would still be subject to federal income tax, and sometimes state income tax.

As mentioned earlier though, you don’t have to take the 529 money out just because your kid got a scholarship. Maybe they would like to use it in the future for grad school? Or – for those families with even longer vision for the future – you can keep the money invested and growing for future grandchildren to use.

529 Considerations for Military Families

529 plans have a few considerations that apply for military families due to how various states sponsor 529 plans compared to their military state of residence.

Just because you PCS doesn’t mean that you need to switch state plans. You can pick any 529 plan, not just the one you are currently stationed at or your home of record.

For most of the military families who don’t pay state income tax, my favorite 529 plan is Utah’s my529 Plan. This plan offers rock-bottom investment cost options from Vanguard and a wide variety of fund options to fit your investment goals.

Compare saving in a 529 plan compared to other military-specific education opportunities like transferring 9/11 GI Bill benefits or the VA Survivors’ and Dependents’ Educational Assistance (DEA) program. If you have transferred your GI Bill benefits to your children, those education funds can reduce the amount you’d need to save in a 529 plan for them.

Financial Planning Considerations

  • Consider “crowdsourcing” your child’s 529 plan. Invite family members and friends to consider contributing to the 529 funds instead of buying yet another toy. Even just small gifts for birthdays or other special occasions can add up over time! Many 529 plans make this easy with gifting codes that make it simple for loved ones to give directly to the fund online.
  • Seperate your short-term and long-term investments. Your 529 plan investment strategy should be directly related to the timeline when you expect to use the funds.

While it is possible to withdraw and pay for K-12 education costs, this can be counter to long-term growth goals, like funding college expenses many years down the line.

If you decide to use 529 funds for K-12 education to take advantage of state tax deductions, consider opening two 529 accounts: one for K-12 and another for longer-term college funding.

Use your timeline to determine your investment mix. Generally speaking, funds that you intend to use in the next few years shouldn’t be invested in stocks due to their potential short term volatility. In plain English, that means you shouldn’t be aggressive when you plan to spend your funds soon.

Most of the time, your best bet is to utilize a default age-based target enrollment fund. These funds automatically diversify between domestic and international stocks and bonds. As you approach the year you expect your student to start college, your investment mix will automatically get more conservative.

  • Keep costs low. Every dollar that you pay in fund investment costs or administrative fees subtracts from the possible return of your investments. While most 529 plans have reasonable, low cost fund options, be sure to double check as you make your investment decisions.

  • Coordinating 529 withdrawals. When taking 529 withdrawals for qualified higher education expenses, keep in mind how they interact with the American Opportunity Tax Credit. In short, this is a credit for qualified education expenses paid for an eligible student for the first four years of higher education up to a maximum annual credit of $2,500 per eligible student. As the taxpayer, you can get 100% back of the first $2,000 of qualified education expenses and 25% of the next $2,000 for a total of $2,500 back on $4,000 spent. Because you cannot “double dip” taking the AOTC for the same dollars you withdraw from a 529 account, it might make sense based on your AOTC eligibility to pay the first $4,000 of college costs out of pocket and take the remainder out of the 529 account.

  • Remember to plan for your own future too. While saving for your childrens’ education is a worthy goal for many people, keep your own future savings goals in mind. While there are a variety of ways to pay for higher education like scholarships, need-based aid, tax credits, and loans, those options don’t exist for retirement. Ensure that you are planning for your retirement as well as college funding or consult a fee-only financial planner who can help you understand your options there.

Happy planning!

Daniel Kopp, CFP ®, Fee-only financial planner; Helping servicemembers & young widowed spouses; Veteran; Widower; Husband; Writer; Speaker; Podcast Host; Financial Therapist

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