What is a 529 Plan?
A 529 plan is a tax-advantaged savings account designed to be used for a beneficiary’s educational expenses. This beneficiary can be a child, another family member, or even yourself.
There are two major types of 529 plans: education savings plans (the most common) and prepaid tuition plans. Education savings plans grow tax-deferred and withdrawals are tax-free if they are used for qualified education expenses. Prepaid tuition plans allow the account owner to pay current tuition rates for future attendance at designated colleges and universities. That means that, most likely, you can lock in a lower cost of college attendance.
What does it mean that a 529 is Tax-Advantaged?
A 529 plan is considered tax-advantaged because it is eligible to grow tax free. If the money stays in the account, no income taxes will be due on any earnings of that account. If funds are used for qualified education expenses when they are withdrawn from the account, those withdrawals are also federally income tax free and, in many states, also free from state tax. Certain states also allow for a deduction or a credit on contributions to the account.
Once the assets are in a 529 plan account, they are generally considered to be out of the owner’s estate for estate tax purposes which can be a significant estate planning benefit.
What is a qualified educational expense?
Although subject to change, there is currently a wide range of educational expenses which would be considered as qualified expenses. Qualified expenses for college include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access and special needs equipment for students attending a college, university or other eligible post-secondary educational institutions. This definition now also includes registered apprenticeship programs.
Up to $10,000 annually can be used on K-12 tuition expenses, and $10,000 per the lifetime of a beneficiary or sibling of the beneficiary can be utilized on student loan repayments. Beginning in in 2024, up to $35,000 of leftover funds can be rolled into a Roth IRA if the fund is at least 15 years old.
What are the upsides?
Aside from the tax benefits of the plan, there may be additional benefits. Others may gift money to an existing 529 account, so a grandparent, aunt, uncle, or other generous individuals can gift money into an existing account to help it grow for the future beneficiary. The owner of the account is able to keep control of the money, make investment decisions, and even change beneficiaries if needed. Anyone, of any age, provided they have a tax ID or Social Security number, can be a beneficiary of a plan. You can open a 529 plan as soon as the beneficiary is born, and let it grow tax-free for as long as possible before the funds are utilized. An account can be opened with a minimal starting contribution — some accounts allow you to open with just $25. Each state has various maximum contribution limits ranging from $235,000 to $553,098 per beneficiary. Filing of a gift tax return may be required if contributions exceed the gift tax exemption for the year (2023 exemption is $17,000). There is, however, a “superfunding” option, which allows you to contribute up to 5 years of gifts without requiring a gift tax return (for 2023 this would be $85,000).
While assets held in a 529 plan that is owned by the student or their parents are considered parental assets on the Free Application for Federal Student Aid (FAFSA), qualified distributions are not included in the base-year income that would reduce financial aid. Assets held in accounts owned by grandparents or other relatives are not reportable on the FAFSA. Beginning with the 2024-2025 FAFSA, distributions from plans owned by a grandparent or other family member will not be reported as income so will also not negatively impact financial aid eligibility.
What are the downsides?
529 plans are not without their drawbacks and pros and cons should be discussed with a qualified financial advisor to understand how a 529 plan can be part of your overall financial plan.
Generally speaking, 529 plans are state sponsored and state-run, which would limit the number of investment options you would have as opposed to your own custodial investment account. This may mean that at certain times the account may not grow at the same rates as an account invested with a financial advisor.
In addition, since 529 plans are state sponsored and state-run, there may be differences in the rules depending on the state. While a beneficiary is not required to go to school or use the funds in the state where the owner created the fund, most open a fund in the state they reside in for ease. There may be advantages or disadvantages depending on the state rules which can add to the complexity of the plan.
Another downside is that the use of the money is limited to qualified educational expenses. If funds are withdrawn from the account and used on something other than qualified educational expenses, you will have to pay tax on the income earned as well as a potential 10% penalty. There are exceptions to the 10% penalty, so planning is important. You can also adjust the beneficiaries easily. In the event your chosen beneficiary chooses not to pursue academic passions, you can change beneficiaries easily and reallocate funds a beneficiary who can benefit from them.
While 529 plans can present a great investment option, they come with complexities that are important to understand. It is important to work with your financial advisor, CPA, and/or attorney to discuss the best option for your individual situation. Contact your Prager Metis advisor today to discuss the options and benefits of a 529 plan can for you and your beneficiaries.