Does a 529 Plan Lower Your Taxable Income?

Students and parents know well the costs of a college education. While we hope a degree affords opportunity and increased income, you also don’t want to strap yourself or your kids with years of debt. It’s important to start as early as possible by contributing to a college savings plan that grows tax-free. Most estate planning attorneys and financial advisors recommend a 529 plan for this education savings purpose.

A “529,” also known as a Qualified Tuition Program (QTP) is a college savings plan sponsored by a state or state agency that is eligible for certain tax benefits, as authorized under the Internal Revenue Code Section 529. It’s similar to a 401(k) account in that after-tax money is invested in a designated investment fund, but accruals are not taxed, nor are withdrawals as long as funds are used for authorized higher educational purposes.

Four Tax and Estate Planning Benefits of a 529

529 contributions offer tax and estate planning benefits:

1. Earnings on the 529 plan account are tax-deferred for federal income tax purposes for both the contributor to the account and the beneficiary. And as long as the withdrawn funds are used for qualified higher education expenses as defined by the Internal Revenue Service (IRS), they are tax-exempt.
2. Contributions, once placed in a 529 plan, are removed from your taxable estate, even though you retain control over the account.
3. Federal law allows for lump-sum contributions in excess of the annual gift tax exclusion ($18,000 in 2024), permitting a single five-year cumulative gift to the plan while taking the exclusion over the next five years.
4. Your state may offer additional tax benefits.

Types of Education Savings Plans

There are two types of 529 plans that taxpayers can take advantage of:

1. College Savings Plan

The most common and better-known is the college savings plan, which allows the account owner to invest money in a selected plan for use by a named beneficiary (mostly) wherever they attend college or graduate school. A 529 can be established by parents, grandparents, or other relatives.

Accounts are state-sponsored, but you’re not required to live in the sponsoring state to participate in a state’s plan. Similarly, the student need not attend school in the state where the plan is located. Several online sources provide ratings of the various state-sponsored funds, and with no residency requirement, you can choose the one that best fits your needs. Total contributions are limited by state to between $235,000 and $575,000. You can have the fund managed, or you can track it on your own, much like a mutual fund. Fees and expenses vary.

Funds saved in a 529 plan can typically be used at any higher education institution and apply to a wide range of education-related costs, including tuition, fees, books, computers, internet access and a certain amount of room and board. Withdrawals are tax-free as long as money is used for a qualifying college expense. Funds can be used for post-secondary education, including vocational training, community college, and graduate school, but not for any pre-college education.

2. Prepaid Tuition Plan

The second type of 529 is a prepaid tuition plan, but only nine states currently offer this option. Prepaid plans allow you to pay for future education at current tuition rates but provide for attendance only at certain in-state public schools to residents of that state. Funds cover only tuition and fees.

There is also a national Private 529 Plan, offering prepaid tuition at a consortium of several hundred private colleges and universities based on the same structure and tax benefits. If your student opts to attend a school outside their prepaid plan, funds can be transferred for use at most other institutions at regular current tuition rates.

Can You Change a 529 Designated Beneficiary?

The beneficiary of a 529 can be changed to another family member with no tax consequence. Thus, if your son opts not to attend college or has money still in the account, you can move the remaining funds over to your daughter for he education. Funds used for a purpose other than post-secondary education will be subject to income tax, as well as a 10 percent tax penalty on earnings.

How Does a 529 Impact Financial Aid?

Be aware that participation in a 529 will have a limiting effect on your student’s financial aid eligibility but in a less severe way than most other savings plans.

When completing a FAFSA (Free Application for Federal Student Aid), the income and assets of the student and the parents are assessed at different rates and reviewed each year the student is in school. A 529 account is considered the parents’ asset and assessed at a maximum 5.64 percent rate—meaning a financial aid award would be reduced by 5.64 percent of the asset’s value.

Find Experienced Tax Planning Help

Tax and estate planning involve sophisticated analysis of intersecting areas of the law. Before you make any decisions regarding a 529 plan, consult with a tax attorney or estate planning attorney in your area. For more information on this area of law, see our tax overview.