How a 529 Plan Can Maximize Savings for College
Legal advice on the little-known tax advantageBy Judy Malmon, J.D. | Last updated on January 27, 2023
Use these links to jump to different sections:
- College or Education Savings Plan
- Prepaid Tuition Plan
- Financial Aid Considerations
- Tax and Estate Planning Considerations
College or Education Savings PlanThere are two types of 529 plans. 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 plan, to between $235,000 and $500,000. 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 expense. Funds can be used for post-secondary education, including vocational training, community college and graduate school, but not for any pre-college education.
Prepaid Tuition PlanThe second type of 529 is a prepaid tuition plan, and only 11 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. The beneficiary of a 529 can be changed to another family member with no tax consequence. Thus, if your daughter opts not to attend college, or has money still in the account, you can move the remaining funds over to your son for his 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.
Financial Aid ConsiderationsBe 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), 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. (This means a financial aid award would be reduced by 5.64 percent of the value of the asset.) Savings in a UTMA (Uniform Transfers to Minors Act) account are counted as the student’s asset, and assessed at a 20 percent rate. A 529 plan held by grandparents would not be an asset of either the student or the parent. However, money paid out from the account would be counted as income on the following year’s application, assessed at the student income rate of 50 percent. Advisors suggest that grandparent funds be saved until the final year of school and used when there won’t be a penalty the following year.
Tax and Estate Planning Considerations529 contributions also offer tax and estate planning benefits:
- Earnings on the plan are excluded from gross income for federal income tax purposes, for both the contributor to the account and the beneficiary, as long as the funds are used for qualified educational expenses.
- Contributions, once placed in a 529 plan, are removed from your taxable estate, even though you retain control over the account.
- Federal law allows for lump-sum contributions in excess of the standard $14,000 per year gift tax exclusion, permitting a single five-year cumulative gift to the plan while taking the exclusion over the next five years.
- Your state may offer additional tax benefits.
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