Why and how to start saving for college with a 529 plan.

By Mia Taylor
Updated July 13, 2021
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An image of a stack of books with 529 on top.
Credit: Getty Images. Art: Jillian Sellers.

Faced with the astronomical cost of college in this country, families everywhere are scrambling to find ways to tackle the expense of higher education—cobbling together savings, student loans, and even using home equity or tapping into retirement funds to help cover costs.

Yet another helpful financial vehicle that can be used to pay for college is the 529 Plan, a tax-advantaged savings account that can be opened when a child is first born (or even before), or anytime thereafter, and used to squirrel away money for the costs associated with college. If you're still not familiar with these accounts, there's no better time than the present to get up to speed. To help with this task, we tapped Patricia Roberts, author of the ultimate guide to 529 plans —Route 529: A Parent's Guide to Saving for College And Career Training With 529 Plans ($15, Amazon.)

What is a 529 plan?

It's an investment plan administered by a state and designed to help families save for future college costs. As long as the plan satisfies the requirements of Section 529 of the Internal Revenue Code, then federal law provides special tax benefits to you, the plan participant, Roberts tells Parents.

"It's up to each state to decide whether to offer a 529 plan. or possibly more than one, and what it will look like," says Roberts. "Every state except for Wyoming has at least one 529 plan available. The District of Columbia has a plan as well."

There are no limits or requirements that you only invest in a plan offered by your home state, but these options are often a good place to begin in terms of research, adds Roberts, particularly given the possibility of a state tax benefit or some other benefit being provided by local plans.

Are there two types of 529 plans?

It's important to understand that there are two general types of 529 plans: prepaid tuition plans and savings plans, says Roberts, and you can participate in one or both types.

"Prepaid tuition plans enable individuals to pre-purchase future tuition at a predetermined rate today on a future student's behalf," explains Roberts. These types of plans are offered by nine states and by what's known as the Private College 529 Plan. 

"The states offering prepaid tuition contracts typically cover in-state tuition and fees at certain institutions," Roberts continues. "They may also allow participants to transfer the value of your contract to private and out-of-state schools—although specifics vary by state and you may not get full value in the event the funds are not used at one of the participating in-state institutions."

Prepaid plans differ from 529 college savings plans which allow for using the full value of your investment account at any accredited college, university, trade, technical, or other professional schools in the U.S. (along with some foreign institutions). The money from this type of 529 plan is subject to market fluctuations and can be used to cover not just tuition but also a range of expenses including other fees, room and board (if the student is attending at least half time), required books, supplies, equipment, and even computers and peripherals, says Roberts.

Are there any additional uses for 529 savings plans?

In a bit of good news for parents everywhere, in recent years, the permitted uses for 529 funds have been expanded to allow withdrawals for a variety of additional education-related expenses.

These new allowances include withdrawing up to $10,000 per year, per beneficiary for K through 12 tuitions for enrollment or attendance at an elementary or secondary public, private or religious school, says Roberts.

In addition, money from a 529 plan can now be used to cover the costs of fees, books, supplies, and equipment required for participation in certain registered and certified apprenticeships.

And here is perhaps the biggest news with regard to expanded use of 529 plans: Up to $10,000 over the life of the 529 account can be used for student loan repayment for the account beneficiary or even a sibling or step-sibling of the beneficiary.

"It's important to note that for such withdrawals, while there will be no federal tax or penalty owed on the account earnings, state tax treatment varies," notes Roberts. "You should confirm with your state whether these types of withdrawals are considered 'qualified.' And if not, what, if any, state tax or penalties might be imposed." 

The benefits

For those who are still scratching their heads and wondering what's so great about 529 plans, here are some of the main takeaways to remember:

First, you get unsurpassed income tax breaks. Your investment grows federal tax-deferred for as long as your money stays in the plan. And when the plan makes a distribution to pay for the beneficiary's covered expenses, the distribution is federal tax-free as well.

Additionally, your own state may offer some tax breaks, such as an up-front deduction or credit for your contributions, in addition to the favorable federal tax treatment, says Roberts.

"Over 30 states and the District of Columbia have deductions or credits that incent residents to prepare for higher education expenses.  Less tax can mean more money for higher education," Roberts explains.

Second, whoever the account owner is (such as you, the parent) will always remain in control of a 529 account.

"With few exceptions, the named beneficiary has no rights or access to the funds. You are the one who calls the shots; you decide when withdrawals are taken and for what purpose," Roberts explains. "As the account owner, you can reclaim the funds for your own use at any time you desire, subject to certain conditions."

There is one caveat to that last point, however: The earnings portion of any nonqualified withdrawals will be subject to income tax and an additional 10 percent penalty tax.

Transfers and Refunds

What's this I hear about a penalty on refunds? What happens if my child doesn't pursue post-secondary education or if I simply end up with more in the account than is needed for schooling costs?

Federal law imposes a 10 percent penalty only on the earnings portion of nonqualified distributions, says Roberts.

"This means that you will get back 100 percent of your principal and 90 percent of your earnings," she explains. "The penalty is not assessed if you terminate the account because the beneficiary has died or is disabled, or if you withdraw funds not needed because the beneficiary has received a scholarship."

You can also change the beneficiary to another qualifying family member at any time in order to keep the account going and avoid (or at least delay) taking nonqualified withdrawals when the original beneficiary doesn't need those funds.

If the original beneficiary does not need the funds or decides not to pursue any form of post-secondary education, who can the account beneficiary be switched to?

The beneficiary can be changed to any of the following relatives of the current beneficiary:

  1. Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them
  2. Brother, sister, stepbrother, or stepsister
  3. Father or mother, or ancestor of either
  4. Stepfather or stepmother
  5. Son or daughter of a brother or sister
  6. Brother or sister of father or mother
  7. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
  8. The spouse of the beneficiary or any individual listed above
  9. First cousin

That penalty doesn't sound so bad. Are there other considerations when considering a nonqualified withdrawal?

Since you hadn't paid tax while the account was growing in value, the earnings portion of a nonqualified distribution that comes back to you, the account owner, will be subject to tax as ordinary income at your tax rate.

"Most 529 plans allow you to direct the withdrawal to the beneficiary, which would presumably keep it in a low tax bracket if tax is owed on the earnings as a result of a nonqualified withdrawal," explains Roberts. "In addition, if you were able to deduct your original contributions on your state income tax return, some states may require you to report additional state 'recapture' income."

Can I transfer my child's existing Uniform Transfers to Minors Act (UTMA) account into a 529 plan?

Many (but not all) 529 plans accept funds coming from an existing UTMA or UGMA. However, because these funds belong to the minor under a custodial arrangement, any withdrawals from the UTMA/529 account must be for the benefit of that minor only.

"Program rules and state laws will generally prevent you from making any beneficiary changes to the UTMA/529 account, and the minor will assume direct ownership of the account when the custodianship terminates at the age of majority," says Roberts. "Parents who are nervous about a child getting their hands on money in an UTMA account, and who may be looking to regain control of the money by transferring the funds to a 529 account, may be disappointed to learn that they are not able to accomplish that objective without violating state laws."

Still, the placement of UTMA funds in a 529 account can provide all the tax and investment benefits associated with 529 plans. Remember, however, that a 529 plan can only accept cash, so any appreciated securities in the UTMA would first have to be sold and capital gains would be reportable on the minor's tax return. Account owners can set up a separate 529 plan account to avoid mixing UTMA funds with non-custodial 529 plan assets.

Do 529 plans impact eligibility for financial aid?

Here's the takeaway on this very important point: 529 plans owned by a student's parent are considered a parental asset and as such, have only minimal impact on a student's federal financial aid eligibility, says Roberts.

"A student's federal financial aid award could be reduced by up to 5.64 percent of the value of the parent-owned 529 account, which is significantly less than a reduction of 20 percent for assets deemed to be owned by the student," explains Roberts.

As an example, a student's award could be reduced by $564 if the value of the parent-owned 529 account is $10,000, she explains.  

"While this impact is not significant, recent changes to the Free Application for Federal Student Aid (FAFSA) made under the Consolidated Appropriations Act in late 2020 make the treatment of 529 plans even more favorable for certain low-income families and for those who utilize withdrawals from 529 accounts owned by persons other than the child's parent like grandparents," continues Roberts.

These improvements are anticipated to go into effect for the 2024-2025 school year and should apply to FAFSA filings two years prior (beginning in fall 2022). 529 plans may, however, have a more significant impact on state and institutional aid, Roberts adds.

"Given that financial aid packages are, however, often largely comprised of student loans, many financial and educational professionals assert that even with an impact on certain forms of financial aid, it is generally preferable to save in advance for higher education than to borrow and repay the cost with interest," Roberts adds.

Families can consult a financial aid professional or a state or educational institutional representative for clarification on how 529 assets may impact their specific situation.

Tax advantages

I thought there were some gift and estate tax advantages with 529 plans, but you didn't mention that as a benefit. Am I wrong?

The gift and estate tax treatment of an investment in a 529 plan is quite favorable, says Roberts.

Your contribution is treated as a gift to the named beneficiary for gift tax and generation-skipping transfer tax purposes. To begin with, your contribution qualifies for the $15,000 (in 2021) annual gift tax exclusion, so most people can make fairly large contributions without incurring the gift tax. (However, you need to be aware of this exposure, particularly if you are making other gifts to the beneficiary during the same year.)

Additionally, if you make a contribution of between $15,000 and $75,000 for a beneficiary, you can elect to treat the contribution as if it were made over a five calendar-year period. This allows you to utilize as much as $75,000 in annual exclusions to shelter a larger contribution. A married couple filing jointly can contribute up to $150,000 in one year. The money (and the growth of your account) gets out of your estate faster than if you made contributions each year.

And the best news is that the asset leaves your estate, but doesn't leave your control. This is a truly remarkable benefit when you compare it to the "normal" gift and estate tax laws. Anyone who is being advised to reduce their estate tax exposure through gifting, but cannot stand the thought of irrevocably giving away their assets, can now have their cake and eat it too. Of course, if you later revoke the account, its value comes back into your estate. Your estate will also have to include a portion of any contribution made with the five-year averaging election if you don't live past the fourth year.

Can I invest for one beneficiary in more than one state's 529 plan?

Yes, says Roberts. You can open accounts in multiple states. You are not limited to investing in your home state.

Can I contribute the maximum amount in more than one state if I want to?

The IRS currently does not require that states count your investment in other states' 529 plans when applying their own contribution limits. But you should be careful not to contribute more on an aggregate basis than you can reasonably argue might be needed for your beneficiary's future higher education costs. Of course, between a pricey private college, medical school, and then business school, you might be able to support a pretty hefty sum.

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