In today’s world, a college education is one of the most expensive assets a young adult can possess. As the price of tuition soars, students and their families often find themselves under a mountain of high-interest debt that can cost as much as a mortgage, but loans aren’t the only option for those looking to earn a diploma. In 1996, Congress amended the U.S. Internal Revenue Code, adding provisions under Section 529 that provide tax relief (as well as a number of other benefits) for families saving for college.
The resulting investment plans – formally called Qualified Tuition Programs, but more commonly known as 529 plans – give students, parents, and other family members an excellent opportunity to pay for higher education while minimizing the financial burden of student loans. Here, the team at Sootchy has compiled everything you need to know to understand the basics of 529 plans; keep reading to learn more.
Though they all fall under the auspices of Section 529 of the IRC, there are many different types of 529 plans out there, almost all of which are administered at the state level. In fact, each state has its own unique 529 plans, which can come in one of three forms: a prepaid tuition plan, a college savings plan, or an ABLE (or 529A) account. Each of these options comes with benefits, so the type you choose will ultimately depend on your family’s savings and investment goals. It’s worth noting, however, that a specific beneficiary (i.e., your child) can have multiple accounts, each in a different state, so you have a wide range of options when choosing how to save for college.
One trait that’s common across the various state programs is the tax advantage that comes with a 529 plan. As money is put into the account, it is invested by the plan administrator, potentially earning significant sums over the years and building up the resources available to pay for your child’s college education. Under Section 529, this income is entirely exempt from federal income taxes, so long as it’s put toward qualified expenses, such as tuition, and some states offer their own financial incentives on top of the federal tax break. That said, some plans come with substantial fees, and others carry greater risk, depending on the type of investment portfolio, so it’s important to shop around before committing to a particular 529 plan.
Before you decide to open a 529 plan on your child’s behalf, consider which type of plan would be appropriate, since each has its own restrictions and advantages. The following are the three types of 529 plans available in the U.S.:
The most commonly used 529 plan is the college savings plan, which is also known as an education savings plan since the 2017 tax law added elementary and secondary school tuition as eligible expenses for 529 plans. However, payments toward primary or secondary education under these programs is limited to $10,000 per year for each beneficiary, and the fact that these payments are required earlier in life mean that the plan has had less time to generate earnings – two facts to keep in mind when considering opening a 529 plan for something other than college.
Generally speaking, college savings plans are much more flexible than prepaid tuition plans, since they can be used to cover expenses like books, computers, equipment, and room and board; some plans even allow you to directly pay qualifying third parties – landlords offering off-campus housing, for instance. Additionally, the funds in a 529 college savings plan can go toward almost any institution of higher learning, including a few outside the country, and they don’t require you to sign any contract. In other words, you can contribute to your 529 plan whenever you want, and you decide the amount of each contribution.
And just as college savings plans offer flexibility in how the funds are used, so too do they offer a variety of investment options that remain firmly in control of the account owner. Some 529 plans offer clearly defined choices, while others allow owners to decide for themselves the kind of returns they want to aim for – and the level of risk they’re willing to accept. Each state has its own version of a college savings plan, though, and since you can sign up for plans around the country, be sure to check out all your options.
While less popular than standard college savings plans, prepaid tuition plans offer some notable benefits that should not be ignored – namely, they help you control the cost of college while making it easier to save for education. Many of the pros and cons of these plans revolve around the fact that they require a contract, one that effectively locks in tuition rates. Obviously, this feature can be overwhelmingly beneficial for those with young or unborn children who won’t be going to college for years or decades, because it guards against the inevitable – and significant – increases in tuition that happen over time. However, because the rate enshrined in the contract is based on the cost of tuition in the state offering the plan, there is relatively little flexibility in choosing schools compared to college savings plans, and most prepaid tuition plans are only available to state residents.
The investment opportunities offered by 529 prepaid tuition plans are limited as well, especially since the account owner has no control over how their contributions are invested. Typically, an account will be handled by a state investment manager who oversees the growth of all the state’s plans with the goal of ensuring that today’s contributions match the cost of future tuition, though it’s worth noting that some states guarantee returns on prepaid tuition plans. However, the funds in one of these 529 accounts can often only be used for tuition and certain fees, not for the additional costs of going away to school, so you may still have to pay some out-of-pocket costs when freshman year rolls around.
Another feature of prepaid tuition plan contracts is that they mandate regular contributions of a certain amount; to stop or change these payments, you’ll have to cancel the contract altogether. Also, friends and family members may find that they have a harder time contributing to a 529 prepaid tuition plan than they would for a college savings plan, and many states don’t offer one at all. That said, these plans require next to no maintenance from account owners, so they may be a good option for those who want to simply set up a 529 plan and forget about it, and the fact that there is rarely any limit on a prepaid tuition plan could make them an excellent option for those looking to put away a substantial sum of money for their child’s future.
The third and final type of 529 savings plan was added in 2014 as part of the Achieving a Better Life Experience (ABLE) Act. This account was specifically designed to help Americans with disabilities cover expenses for education, as well as things like housing costs, healthcare expenses, employment support, and financial management services. In practice, a 529A account works in much the same way as a traditional 529 college savings plan; contributions and distributions come with lots of flexibility, and residents around the country can pick whatever state plan they want.
However, there are a few notable differences between 529 plans and 529A accounts, aside from the expanded coverage of the latter. One point of particular importance is the fact that the first $100,000 in a 529A account will not count against a beneficiary for Supplemental Security Income (SSI) purposes, so you can confidently save a significant amount toward college tuition and other expenses without any loss of income. Should your account grow beyond this limit, you’ll lose SSI assistance, but once it dips below that $100,000 mark, those benefits will resume once again. ABLE accounts also come with a cap on savings, albeit a fairly high one; depending on the state, you can keep between $235,000 and $529,000 in your ABLE account.
As mentioned above, 529 plans can be used for a variety of educational pursuits, though their potential differs from one type of plan to the next. Prepaid tuition plans, for instance, are most often used to pay for in-state public universities, though account owners generally have the option to put the funds toward a private college or university, if they want. If you live in a state with a wealth of high-quality schools, either public or private, a prepaid tuition plan might make sense.
College savings plans, on the other hand, are more popular because they can be used to pay for a number of different expenses related to education at almost every level. Up to $10,000 a year (per beneficiary) can be put toward a public, private, or religious elementary or secondary school, while any amount can be used to cover the cost of tuition at a college or university anywhere in the country, and some international institutions as well. In addition to tuition, a 529 college savings plan can help secure books, room and board (as long as the student is enrolled half-time or full-time), and essential equipment, such as a computer.
ABLE accounts offer the greatest flexibility of all, since they’re intended to help with lifetime costs related to an individual’s disability. If you have a 529A account, you can use those funds to cover expenses related to healthcare services and equipment, housing arrangements, money management, employment training, and more.
Even with the funds saved in a 529 plan, many families rely on financial aid – both from the state and federal governments and from colleges and universities – to cover the cost of tuition or room and board. Given that so much of the financial aid awarded to students is based on an assessment of financial need, it’s reasonable to worry that savings in a 529 plan could have a negative impact on a student’s financial aid.
The truth is that the funds in your 529 plan will probably factor into any financial aid decisions, but to a much lesser extent than you might expect. While each educational institution sets its own policies regarding 529 plans and financial aid, government assistance offered through the Free Application for Federal Student Aid (FAFSA) only considers a small portion of 529 funds when awarding aid, as long as the account owner is one of the beneficiary’s parents.
The calculation governing the aid amounts is largely based on what’s called your Expected Family Contribution (EFC), the amount the government assumes you can afford to pay toward college on your own. This determination takes into account all the financial assets available to a family, including taxed and untaxed income, as well as details like dependency status and the size of the student’s family. To ensure that your child gets the most aid possible, it’s important to keep your family’s EFC as low as possible, which means considering the effect a 529 plan could have on it.
First of all, any 529 plan with less than $10,000 in it will not be counted toward your EFC at all, so it will not impact awards given through FAFSA. Above that amount, only 5.64% of the balance in your 529 plan will count toward your EFC – a tiny portion by any measure. However, if the 529 account is in the student’s name, the plan will be counted as that student’s asset, and 20% of the amount will be added to their EFC; even worse, any 529 plan owned by a non-parent relative, such as an aunt, uncle, or grandparent, will have 50% of its value added to the EFC calculations, which could significantly limit the federal financial aid given to a student. That said, as long as you’re careful about whose name is on the account, the money you’ve saved in your 529 plan shouldn’t have much of an impact on financial aid for your child.
Although they were created through the federal government’s Internal Revenue Code, 529 plans are administered at the state level, which means that they can vary pretty significantly – in the particulars, at least – from one state to another. Certain characteristics must be uniform across state lines for each account to meet the definition of a 529 plan, such as the limitations on how funds are used, but features like state tax benefits and investment options are up to each individual state.
To illustrate this point, let’s look at the 529 plan options in three very different states: California, South Dakota, and Virginia. The first two states offer only a single college savings plan, while Virginia has three plans to choose from – a prepaid tuition option (which is only open to Virginia residents) and two types of college savings plans. Those who live in California and opt for the state’s ScholarShare 529 plan can receive state matching grants that can make it easier to get started with a plan, whereas residents of South Dakota or Virginia don’t have this advantage; over in Virginia, however, a family with any one of the state’s plans may be eligible for financial aid benefits, and Virginia is the only one of the three that offers state tax credits or deductions for those with a 529 plan.
It’s also important to remember that the differences between plans involve more than just the unique benefits of each; the cost of each plan much be considered as well. For instance, someone looking to save for college with South Dakota’s CollegeAccess 529 plan will have to make a minimum initial contribution of $1,000 to get started, while two of Virginia’s plans have no minimum, and California only requires a single dollar to sign up for their 529 plan. In addition, there are plan fees to keep in mind, the highest of which come from advisor-sold plans (those handled through a middleman). Fortunately, most 529 plans don’t have residency requirements, so if your home state doesn’t have an attractive option, you should feel free to look at offerings around the country before making a decision.
Even with decades in which to save for tuition, housing, and other college expenses, it can be difficult to ensure that your child has the funds they need to finish their degree with minimal debt, but the tax benefits offered by 529 plans can go a long way toward making this goal more attainable – and affordable. In fact, the tax benefit of a 529 plan is one of its most important traits, so let’s take a closer look at how these accounts are treated under state and federal tax codes.
Regardless of the source, most Americans have to pay income taxes on whatever money they earn over the course of the year, including those generated passively through investments. If you buy stocks or bonds, for instance, the money you end up making will be subject to capital gains taxes – unless those investments were made through a 529 plan. That’s because of the chief benefit of 529 plans: that earnings are not taxed by the federal government, as long as they are spent through qualified distributions.
In practice, an account owner with a 529 plan can spend those funds on elementary or secondary schools (up to $10,000 per year per person), apprenticeship costs, or even student loans (up to a $10,000 lifetime limit per person), all without incurring income tax when the money is earned or spent. On top of this federal tax break, many states offer their own tax credits or deductions, typically for those who use a plan in the state where they reside; check the benefits offered by your particular state when shopping around for a 529 plan.
Most of the time, gifts to other people – defined by any contribution that does not elicit an equally valuable return – are limited through a federal gift tax, the threshold of which changes yearly to account for inflation. In 2020, for example, the most you can give to someone without incurring a tax is $15,000, and under U.S. tax laws, any contribution to a 529 plan is considered a gift. However, there is a unique tax provision governing donations to a 529 plan that makes it advantageous to contribute a large sum all at once.
Under this provision, someone looking to contribute to a 529 plan can treat a contribution as though it was made over the course of five years, rather than all at once; in other words, a donation of $75,000 to a 529 plan will not trigger the gift tax, since it can be treated as five separate $15,000 contributions, which falls within the limit. Because the investments made through these plans provide compounding returns, a large upfront deposit can generate much greater earnings over time, and thanks to the gift tax allowance for 529 plans, a sizeable donation can be made tax-free.
For families with significant wealth, the U.S. estate tax can represent a significant financial threat, so it’s worth noting the benefits of 529 plans for those who have to worry about this issue. Though there is still the gift tax to consider when making contributions of more than $15,000 per year, anyone looking to avoid the estate tax may want to place some of their assets in a 529 account because it removes those funds from their estate without forcing them to surrender control.
These accounts can be revoked or emptied at any time, so the money is still available if needed; keep in mind, however, that there will be a 10% penalty and income tax on earnings if the funds are put toward non-qualified expenses, and money placed into a 529 plan may still factor into estate tax calculations if the contribution was made within five years of the estate owner’s death.
Tax benefits are undoubtedly an important element of 529 plans, but even the most generous tax breaks won’t amount to much if the account doesn’t generate earnings – tax-free or otherwise. Whether you choose a 529 plan with an automated investment portfolio or one that you manage yourself, it’s critical to consider the kinds of returns you can expect on your account, not to mention the kinds of risks you might be taking with your money. Here, we’ll look at some of the basic rules regarding investment options for 529 plans and the types of portfolios available; keep reading to learn more.
Depending on the type of 529 plan you’ve selected – namely, whether it’s a prepaid tuition plan or an ABLE/college savings plan – the rules governing investments can vary significantly. Overall, those who signed a contract for a prepaid tuition plan have no say in how that money is invested, instead relying on a state administrator to ensure adequate growth; by comparison, those with a college savings plan or ABLE account enjoy much greater flexibility, though there are limits.
Whatever the nature of your 529 plan, you are only allowed to make two investment changes per year, but there is some leeway here. At any point, you can alter how you want future contributions invested, which doesn’t count as one of your two changes per year. Also, any changes from one plan offered by a state to another within that same state will count as a single investment change, not a rollover, but you have to make any and all transfers or reallocations simultaneously for them to be considered one change.
It’s also worth noting that any investment change made by the plan manager, not the account owner, will not be counted toward your yearly limit. In some cases, workarounds exist – for instance, changing beneficiaries at the same time you change investments won’t count toward your two-per-year limitation – so even if you’ve already made two investment changes, you might still be able to make another.
The automated option for 529 investments is the age-based portfolio, which changes as the beneficiary of the plan gets older. When a 529 plan is opened with an age-based portfolio, the investments tend to be riskier; after all, it could be a decade or more before a beneficiary needs the funds, so there’s time to make up losses, and greater risk could mean greater returns. As a child gets closer to college, however, the investments get more conservative to help guard the plan against losses and ensure the integrity of the account. This option is generally better for families unfamiliar with investing or those who prefer a hands-off approach, and it still has the potential to provide sizeable returns on contributions.
If you’re an experienced investor with a clear idea of what they want out of a 529 plan, a static portfolio might be the way to go. Rather than funds being allocated automatically, the investments made in a static portfolio are controlled by the account owner and only change at their direction. Owners may opt for a target risk portfolio, for example, or an individual portfolio, and they can be as aggressive or conservative as they like. That said, manual investments may come with greater risk, and remember that only two changes are allowed per year.
Saving for your child’s college education is a serious endeavor, and it’s one worth doing right. If you picked a 529 plan – either years ago or just recently – and have decided it’s not performing up to your standards, you might consider switching to a new plan that may provide better returns, come with lower fees, or offer a wider variety of investment options. However, considering all the restrictions on how 529 funds can be used, it’s worth asking: Can you switch 529 plans? In general, the answer to this question is yes, though there are – predictably – a few caveats for those who want to roll over the funds in one 529 plan into another.
The first and simplest way to move funds out of one 529 plan and into another is through a direct rollover, which is handled by the administrator of the plan you wish to move to. To execute this transfer, you’ll need to fill out a request form detailing the change and providing personal information about the plan’s owner and beneficiary. Depending on the state, you may also be required to provide a medallion signature guarantee before your current plan’s administrator will release the funds; you should be able to get this guarantee from your bank or credit union. Once you’ve met these requirements, the funds will be transferred, and you’ll start receiving benefits under the new 529 plan.
The second method of rolling over funds to a new 529 plan is an indirect rollover, which requires a more hands-on approach on the part of the account owner. To move funds this way, you’ll need to withdraw them from the current account yourself – which, as with a direct rollover, may mean a medallion signature guarantee – then deposit them into a new 529 plan while indicating that the move is a rollover contribution. You only have 60 days to make the switch, however, so be sure to pick out a new plan before initiating the process; otherwise, the withdraw will be treated as a non-qualified distribution and be taxed and penalized accordingly. Keep in mind that an indirect rollover also requires a detailed breakdown indicating which portion of the funds came from contributions and which portion was earnings, or else it will all be considered earnings.
Whether you choose to pursue a direct or indirect rollover, check the policy of the state managing your current 529 plan before finalizing the transfer, since some states apply non-qualified distribution taxes and fees to any outgoing rollovers, possibly eliminating any gains or state tax benefits you earned over the life of the plan.
If your efforts to cover college tuition were even more successful than you’d hoped, and you wound up with more money in your 529 plan than you needed, congratulations! Now it’s time to figure out what to do with those excess funds. Thankfully, you have a few options, though the nature of a 529 plan limits distributions to education-related costs in most cases.
At any point in time – including before your child has entered or finished college – you can withdraw funds from your 529 plan for any reason; however, there may be a penalty for doing so. If earnings from the account are used to cover a non-qualified expense (such as paying a credit card bill, buying a car, etc.), then expect to be hit with federal (and possibly state) income taxes in addition to a 10% penalty. This same restriction applies even after the beneficiary of the account has graduated from college, so you won’t be able to simply recoup the leftover money scot-free.
That said, the funds left in the account can still be useful, and earnings will still be tax-free if used correctly. Possible applications for leftover money in a 529 plan include:
• Changing the beneficiary of the account and using the funds for someone else’s education, including your own
• Rolling over the leftover funds into an ABLE account
• Saving the funds in case of future enrollment in grad school
For some families, an unexpected change can mean that the money in their 529 plan is no longer needed; in certain circumstances, this can allow an account owner to withdraw the funds in their 529 plan without incurring the usual 10% penalty, though income taxes will still be applied to any earnings in the account. Should one of the following events occur, you’ll be able to take advantage of this provision:
• Your child receives a scholarship
• Your child enrolls in a U.S. military academy
• Your child is disabled due to illness or injury
• Your child passes away
Ultimately, what happens to leftover money in a 529 plan will be up to the owner of that particular account, since they have unrestricted access to the balance on the account at all times and can use it as they see fit; just keep in mind that an end to college aspirations doesn’t necessarily mean an end to taxes and penalties