529 Plan: What you need to know | Understanding Tax Benefits

What is a 529 Plan? 

The 529 Plan is a tax-advantaged savings plan for education in the United States. The 529 Plans are also referred to as qualified tuition programs or Section 529 Plans. It has grown through the years covering K-12 education in 2017 and apprenticeship programs in 2019. There are two major types of the 529 plan: Savings Plan and Prepaid Tuition Plan. 

Points to Consider:

• 529 plans are tax-advantaged accounts that can be used to cover educational expenses from kindergarten through graduate school.
• There are 2 basic types of the 529 Plan: Savings and Prepaid Tuition.
• The rules of 529 plan are state specific therefore they differ state to state.

How do 529 Plans work?

The 529 plan takes its name from Section 529 of the federal tax code. These plans are administered by the 50 states and District of Columbia. Typically the 529 Plans are established by parents or grandparents on behalf of their child or grandchild (account’s beneficiary) but these plans can be opened by anyone. In some states, the person who funds the account may be eligible for a state tax deduction for their contributions.

Note: The money in the 529 account grows on a tax-deferred basis until it is withdrawn. As long as the money is used for qualified education expenses, as defined by the IRS, those withdrawals aren’t subject to either state or federal taxes. In the case of K-12 students, tax-free withdrawals are limited to $10,000 per year.

Are there any Limits on Contribution?

No. There are no limits on how much an individual can contribute to a 529 account each year, but many states put a cap on the total contribution. These limits range from $235,000 to over $500,000.

Types of 529 Plans

Let’s understand the two types of 529 Plan here. The two types have some significant differences.

1. Savings Plan: The Savings plan is more common compared to the other type. In this plan, the account holder’s contribution is typically invested in a selection of mutual funds. Account holders can choose the funds they want to invest in, and how those funds perform will determine how the account grows over time. Many 529 plans also offer target-date funds with adjustable holdings with respect to time, becoming more conservative as the beneficiary gets closer to college age.

Withdrawals from the 529 college savings plan: The withdrawals can be used for both college and K-12 expenses. Qualified expenses include tuition, fees, room and board, and related costs.

Note: A 2019 federal law, the SECURE Act, expanded tax-free 529 withdrawals to include registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for both account beneficiaries and their siblings.

2. Prepaid Tuition Plans: These plans are limited to some states and higher education institutions. The general principle in this plan is that it allows you to lock in tuition at current rates for students who may not be attending college in the coming years. (Prepaid plans are not available for K-12 education.)

The funds in the Prepaid Tuition Plan account also grow over time and are tax-free at withdrawal. A difference here is that the prepaid tuition plan doesn’t cover the room and board charges unlike savings plan.

Note: Prepaid tuition plans may be restricted to certain colleges, whereas the money in a savings plan can be used at just about any eligible institution.

529 Plan Tax Benefits

Saving for a child’s education is already a task in itself. The expenses are growing year on year and the best part about these plans are that they help you with your taxes. Here, let’s explore the tax benefits of the 529 Plan one by one:

• The earnings from a 529 Plan are exempt from both federal and state income taxes (only if the money is used for qualified educational expenses)
• Any other withdrawal is subject to taxes plus a 10% penalty (exceptions: certain circumstances, such as death or disability)
• The money contributed to a 529 plan isn’t tax-deductible for federal income tax purposes. However, 30+ states provide tax deductions/credits of varying amounts for contributions to a 529 plan.
• Generally, you’ll need to invest in your home state’s plan if you want a state tax deduction/credit. If you’re willing to forgo a tax break, some states will allow you to invest in their plans as a non-resident.

Transfer of 529 Plan

529 plans have very specific transferability rules, governed by the federal tax code (Section 529). You can transfer to another 529 plan once per year, unless a beneficiary change is involved. You don’t need to change plans to change beneficiaries. You can simply transfer the plan to another family member, who can be:

• Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.
• Brother, sister, stepbrother, or stepsister.
• Father or mother or ancestor of either.
• Stepfather or stepmother.
• Son or daughter of a brother or sister.
• Brother or sister of father or mother.
• Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
• The spouse of any individual listed above.
• First cousin.

Education Plan for Child

Saving for your child’s education is important given the current rate of inflation around education in the states. The earlier you start saving, the better. A 529 plan provides you the opportunity of having more time and utilizing the benefits of compounding. With a prepaid tuition plan, you’ll most likely be able to lock in a lower tuition rate, since many schools raise their prices every year.

The 529 Plan also offers flexibility in terms of usage of the account if the beneficiary gets a scholarship or drops the idea of going to a college. There are several options to choose from:

• Change the beneficiary to other relative
• Continue the current beneficiary in case they change their mind about attending college or later go on to graduate school
• If nothing else, you can always cash in the account and pay the taxes and 10% penalty

SBNRI: Your one stop solution

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