Having shared a comprehensive overview of financial products available to parents looking to save for their child’s college education Parentology is aware — questions abound. With that in mind, we spoke with Jim DiUlio, the Chair of the College Savings Plans Network. DiUlio unpackaged 529 college savings plans in greater detail; what they are, what to watch out for, and how they’ll benefit your future grad.
What is a 529 college savings plan?
A 529 plan is a college savings plan that allows parents to invest in diversified, low-cost stocks and bonds, and then withdraw the money, tax-free, for their child’s education. A 529 plan differs from an Education Savings Account (ESA) in that they allow for investing more than the $2,000 annual limit, making it a good alternative for those who either don’t qualify for an ESA or want to contribute more than the maximum allowance. “It’s a great investment that lasts a lifetime,” DiUlio says.
Under a 529 plan, funds can be allotted towards undergraduate or graduate studies at an accredited two- or four-year campus in the United States. Because you (the parent) are the account holder, the savings in a 529 technically belong to you.
Which States Offer 529’s?
529 plans are state-specific and differ in features and benefits, but you can contribute to a 529 plan in any state that offers one. In fact, your choice of college is not affected by the state that sponsored your 529 plan. For example, you could live in Vermont, buy a 529 in Kansas and attend a college in California. Make sure to research the features of each before making your decision.
A 529 plan offers tax-free savings growth and withdrawals when those funds are used towards ‘qualified’ education expenses, including tuition, books, computers, room and board. “The accounts themselves are generous, and allow for a range of expenses,” DiUlio says. The beneficiary is allowed tax-free withdrawals of up to $10,000 per year, for qualified tuition expenses at private, public and religious K-12 schools.
Some states offer state income tax deductions to investors, as well as tax credits for contributions to the 529 plan. “All states offer a variety of embellishments, tax deductions or credit,” DiUlio says. “Grandparents or relatives can add to the 529 account and get a tax credit.” Since your contributions are made using after-tax money, it will never be penalized.
You’re in control
As the contributing parent, you’re in the driver’s seat. You control the funds, not the beneficiary, which helps ensure the money is put towards higher education.
Salary isn’t a factor
Unlike a Roth IRA, 529 contributions aren’t limited by your income level. However, there are limits to your yearly contributions; depending on your state, you may have to pay gift taxes on larger annual contributions.
Most plans have minimum initial contribution requirements, but your deposits beyond that are your call. Some people set up automated monthly deposits. “You can get into a 529 for as little as $15 or $20 per month,” DiUlio says. “Using something as simple as a payroll deduction can get you into the habit of budgeting and saving.”
Conversely, you can make lump-sum contributions. “The earlier you start, the better,” DiUlio advises. “Start in small amounts, birthday money, holiday gifts, etc. A 529 is really flexible that way. You can deposit what you want, when you want.”
It’s not even necessary to wait until a child is born to start using a 529 savings plan. You can start a 529 plan, with you as the beneficiary, then add your child as the beneficiary once they’re born.
What to watch out for:
While there are no capital gains taxes deducted upon withdrawal, you don’t get to deduct your contributions on your federal tax return. Some states offer deductions on the state income tax return if you’re a resident of that state.
Investments can be age-based, which means the younger a beneficiary, the greater the equity. “I can’t overstate the importance of time,” DiUlio emphasizes. “While we have both age-based and enrollment-based options, you would obviously have more resources available if you start investing at [age] four than you would if you started saving in high school.”
Most colleges consider will consider your 529 money when assigning financial aid. However, 529s are considered a ‘parent asset’, the same as money in your checkbook or savings account, and as such don’t have an adverse effect.
Also known as a qualified tuition plan, a 529 has specific rules about how the money can be spent and what constitutes a “qualified” education expense. Generally speaking, qualified education expenses include things like room and board, books and associated supplies.
As such, if your child decides not to go to college after 18 years, you may wind up paying a tax penalty if the money is withdrawn and spent on unqualified education materials.
While parents can save and invest while not paying taxes on the earnings, “the account owner may have to pay both income taxes on the earnings and a 10 percent tax penalty on all the money that’s withdrawn from a 529 plan,” according to US News.
How to mitigate tax penalties
Wait to withdraw funds
Your child may choose to take a gap year or get a job for additional savings before starting college. Similarly, you may decide to allot the earnings towards grad school. It’s best to determine a time frame for withdrawal, rather than liquidating right away and paying tax penalties.
If it becomes apparent that your child will not be going to college, you can decide to transfer ownership of the funds directly to him. This means your child will assume the tax penalties should he decide not to pursue higher education. “The owner of the account always has control over the program,” DiUlio says. “The dollars can be transferred while you keep tax deduction if your child decides not to go to school.”
Save the funds for future generations
The recipient doesn’t have to be your child. Once your grandchild is born, you can change the plan to list him as the beneficiary. In fact, earnings will continue to accrue, tax-free, until he is ready to use the money, without you ever having to add any additional funds. “This generational component means that someone will have benefitted from these earnings, now or in the future,” agrees DiUlio.
Use the funds for your own education
If your child doesn’t wind up needing or using the earnings from a 529, you can change the beneficiary to yourself. Enroll in a university or college course and add new skills to your own career toolkit.
Establish an emergency account
Penalties are due when money is withdrawn, so keep the funds in your 529 plan until you, or someone in your family, really needs the money for higher education. This way, your money can continue to earn interest.
“We’re about investing for the long haul,” DiUlio says. “So many jobs require schooling. A 529 plan is specifically designed for education savings. You’re free to decide if you’re investing in your child’s education, your grandchild’s or even your own. This is an investment in futures. The opportunities are there for success.”