Money Basics: What is a 529 Plan?

Inside: Ever wonder what is a 529 plan and if your child should have one? Find out why it is a good option for college savings.

Do you have a child and struggle with the idea of saving money for college? Maybe you have heard of different college savings plans, but you are wondering exactly what is a 529 plan.

It is not an uncommon question. An Edward Jones survey showed that the majority of Americans still do not know what a 529 plan is.

What is a 529 plan?

Over 20 years ago (in 1996) Congress introduced the tax-advantaged 529 college savings plan. It is named after section 529 of the tax code, in case you were wondering.

The plans are operated either by the state or an educational institution. Anyone 18 or older can open a 529 account for a beneficiary. Normally, a beneficiary would be a child, grandchild, or other young relative. But, you can open a 529 account for yourself.

Types of 529 plans

There are two types of 529 plans available.

Prepaid tuition plans

A prepaid plan will allow you to prepay in-state public college tuition. This type of plan will lock in the current cost of tuition.

However, withdrawals can normally only be used towards tuition and fees and not other costs such as room-and-board or books. Some states may allow the funds to be converted to use for private or out-of-state tuition, but check plan details carefully.

Not every state offers this type of plan and, due to lack of popularity, most have shut down.

Savings plan

A 529 savings plan is the most common of the 529 plans. In this type of account, the plan offers a set of mutual fund options for investment. Often you have the choice of selecting separate funds to invest in given your risk tolerance or there may be age-based or target-date funds which automatically adjust the investment risk for you.

Related: 7 Surprising Facts About 529 Savings Plans

Where can you use 529 plans

Almost every state offers a 529 plan and they can be used at schools nationwide. They can even be used outside of the U.S. at schools that accept students receiving federal financial aid.

In fact, you could live in Oregon, invest in both Oregon and Utah plans, and your child could use the funds to attend college in Massachusetts. Check to make sure your college is eligible under 529 rules. There is a list here http://www.savingforcollege.com/eligible_institutions/.

Many 2-year colleges, vocational and technical schools are also eligible in case your child opts out of a four-year college. If your child is ambitious, she could use the money for a graduate degree programs as well.

Related post: Baby on the Way? Savvy Money Tips for New Parents

What is a 529 plan’s tax benefit?

Federal

There are currently no federal tax benefits for contributions made to a 529 plan. However, the earnings will grow tax-free. When withdrawing the money, as long as it is used towards qualified educational expenses, it will not be taxed.

State

Some states do offer either tax deductions or tax credits on contributions made to their state plan. You will want to research your options in your state.

If you live in a state with no income tax or tax benefits for investing in the state 529 plan, then definitely take a look at 529 plan options in other states.

Unlike some other educational savings plans, a 529 has additional benefits such as:

• There are no income limits
• No age limits
• No annual contribution limits*

*Contributions to a plan are often limited to a total of somewhere between $250k-$500k, depending on the plan. Also, when making contributions, you will want to watch for gift tax exclusion limits.

Other advantages

• Unlike a UTMA/UGMA account, the account owner retains control rather than the child/beneficiary gaining control of the account.
• If your child decides to not attend college, you can name another family member as beneficiary.
• There are no income limits that would make you ineligible to open or contribute to an account.
• In most states, there is no age limit for when the money has to be used.
• Anyone can contribute to the account.
• Distributions for qualified expenses on a custodial parent-owned or student-owned account do not count towards “base-year income” on the FAFSA.

What can money from 529 plan pay for?

Money for a 529 plan can be used by students attending school at least half-time to pay for “qualified higher education expenses” such as

• Tuition
• Room and board (limited)
• Books and supplies
• Computers and related equipment, if required

Remember to keep detailed records and ask the school financial aid office for more details about qualified expenses and their limits. Any money from the 529 plan not used for qualified expenses loses its tax benefits and incurs a penalty.

If you have a 529 plan, once you get within a couple years of your child attending college, it’s probably worthwhile consulting a financial planner or tax advisor on withdrawals, especially if you are looking for scholarships or additional educational tax benefits such as using the lifetime learning credit.

Figuring this all out can seem intimidating, and the information here just scratches the surface. Don’t be afraid to reach out to a planner or even the state plan administrator. You can also find more in-depth information at sites CollegeSavings.org or SavingForCollege.com.

Overall, 529 plans are a great way to save for college expenses and they also provide nice tax benefits.

Have you started, or used, a 529 college savings plan?