529 Plans are education-oriented investment accounts to which parents, grandparents, friends, or the occasional rich uncle, may open and contribute money that can be used toward qualifying education expenses.
These qualifying expenses include tuition and other ancillary expenses, such as room and board, and even laptops and software. Many questions arise for those who are considering opening a 529 account, such as:
- What if my child decides that she doesn't want to go to college, what happens to the money that's been contributed over the years?
- Does the money accrue interest or grow in value over time?
- Are there any tax benefits to a 529 plan?
We answer these and other frequently asked questions.
What does "529 Plan" refer to? Why is it called a 529 Plan? The name 529 Plan is derived from section 529 of the Internal Revenue Code, which allows for and regulates this kind of financial instrument. The purpose of a 529 plan is specifically to encourage parents to invest in their children's education, and thereby assist future generations in getting an education.
The technical term for 529 Plans is "qualified tuition plans", of which there are two kinds:
Prepaid Tuition Plans:
A type of 529 plan that lets an account owner purchase units or credits at participating colleges or universities for future tuition for the account beneficiary.Investor.org
Education Savings Plans:
A type of 529 plan that lets an account owner open an investment account to save for the account beneficiary’s qualified higher education expenses or tuition for elementary or secondary public, private, or religious schools.Investor.org
Choosing a 529 Plan
Frequently Asked Questions
Are 529 plans really worth it?
Given the rising cost of college, a 529 plan might be a good idea. One benefit is that you can contribute over time and the money will accumulate and compound. If the time frame is ten years or so to contribute funds, then the account will get the benefit of compounding returns over time. There are also tax advantages with the money that has grown over the years; the growth is tax free. If someone has invested $15,000 over the years, and it grows to $25,000, then the $10,000 growth amount is not taxed when spent on qualifying education expenses. Also, certain plans allow for fixing or freezing the tuition rate in time, so that when the tuition rises over the intervening years, the tuition rate is fixed in time when the account was opened for the beneficiary. This can be a significant savings over the course of years. However this relegates the child to attend a state school in the state in which the plan was opened.
What happens to a 529 plan if not used?
The 529 plan account can be transferred to a family member and used for qualifying education expenses. It may not be transferred to an IRA or other retirement account. The money may be withdrawn (and not spent on qualifying education expenses), but the growth that the money had over the life of the plan will be subject to a 10% tax and additional federal and or state taxes. The growth that the 529 plan made over its life will be taxed at the commensurate tax rate for federal and/or state taxes, and a 10% tax on top of that will be assessed. The 529 plan's assets may not be subject to the 10% tax if the beneficiary has gotten a scholarship (if the withdrawal is the same amount or less than the scholarship) or the beneficiary has died, or become disabled. But in the circumstances of scholarships, death and disability, the amount withdrawn that is from growth from the 529 plan will still be subject to the state and/or federal taxes.
Can you lose money in a 529 plan?
Yes. Given that 529 plans are investments into various investment options, such as international or United States stock funds, bond funds, money market accounts, and real estate funds, there are risks involved, such as the stock market crashing. Such is the nature of investments that have the potential for earning money; they also have the potential for losing money. But with that being said, you or whomever opens the account have the purview of determining what these investments are and to what extent you want the growth and risk tolerances to be. A low risk portfolio can mitigate the potential for loss, and create positive returns over time.
What happens to a 529 plan if your child doesn't go to college?
What happens to a 529 plan in your child doesn't go to college depends on how the plan is used. It may be transferred to a qualifying member of the beneficiary's family, with no penalties or taxes, and used for qualifying educational expenses. If not transferred, and money is withdrawn, then the amount that the money has grown since the account was opened, will be taxed at the commensurate state and/or federal tax rate, plus an additional 10% tax assessed. Keep in mind that these taxes are only applied to the dollar amount that the account has grown since it was opened (and doesn't apply to the entire amount). The amounts that were contributed over the life of the 529 plan were already taxed and won't be subject to these taxes (these taxes only apply to the amount that the account grew in value).
Should I open a 529 for each child?
Yes. This allows for all children to attend private school or college contemporaneously. One account applies to one beneficiary. One account may not be used for multiple expenses at the same time. If one child is finished with college (or quit or whatever the case may be, and are no longer attending), then another child may become the beneficiary after transferring the account to them, and then paying for the education expenses (including private school and college). It's easier and doesn't create conflicts of time to have a 529 plan opened for each child. This can also create a scenario of fairness in contribution amounts to each child's 529 plan account.
Does having a 529 hurt financial aid?
Not much. The 529 plan is considered an asset of the parent(s) at a total amount of 5.64% of the asset, so it doesn't affect the qualifications or eligibility of the student to receive financial aid very much, when using the FAFSA (Free Application for Federal Student Aid).
Is a 529 plan better than a savings account?
Generally speaking, the answer is yes, 529 plans are better than a savings account. Savings accounts generate almost no money in interest. 529 Plans generate more money as compared to savings accounts given that 529 plans are invested into various investment vehicles. The money earned over time is also tax free in 529 plans, if spent on qualifying education expenses. Savings accounts have the benefit of not being risky, but no upside in rate of returns. A properly oriented 529 plan portfolio can mitigate risk and earn more return, tax free, over time.
Can I buy a laptop with a 529 plan?
Yes. Laptops are considered to be within the purview of related and qualifying educational expenses. Software, such as Microsoft Word, Excel, etc., is also covered.
Are 529 contributions tax deductible?
The contributions to the 529 plan aren't tax deductible for federal taxes, but may be tax deductible for state taxes depending on the state. However, the growth of the money is tax free. So if contributions have doubled in ten years or so, from a contributed amount of $10,000 for example, which has grown to be $25,000 in the intervening years, then the growth of $15,000 is tax free. There is a caveat to this tax exemption rule; the money must be spent on qualifying education expenses. If the money isn't spent on qualifying education expenses, then there is a 10% penalty assessed and taxes on the amount that the money has grown over the years. However, there is another scenario which can affect the tax situation: if your child gets a full scholarship, then the 10% penalty is waived (but the tax remains) if an amount up to the scholarship amount is withdrawn.
Does a 529 plan pay for tuition at any school in the U.S.?
529 plans are able to pay education expenses at colleges, universities, and vocational schools that are eligible for federal student aid, as defined by the Department of Education.
Do I have to buy a 529 plan in my state?
No. Parents are not relegated to buying a 529 plan in the state in which they live; parents have the option to buy a 529 plan in other states. It is prudent to research state deductions and determining if your state offers a deduction for in-state plans. If the deduction is small, its benefit may be irrelevant when compared to other state options that offer lower fees and have more and higher quality investment choices. In other words other state's 529 plan's advantages may outweigh the given deduction for using the in-state 529 plan where you live.
Can 529 plans be transferred?
Yes, 529 plans can be transferred between immediate family members of the beneficiary, and to you if you opened the plan. If a child has finished college (or stopped attending, etc.), and there are still funds available in the plan, it's perfectly permissible to transfer the account to another child if there is no overlapping of college attendance (and expenses being used from the same 529 plan) between the two children. It's not allowed to use the 529 plan for two children at the same time; a transfer must be made prior to using the 529 plan on another child. The same prohibition of overlapping education expenses is true for anyone else in the immediate family; the transfer must be made and the expenses not overlap.
What are the requirements to open a 529 plan?
Anyone who is 18 years old or older, and who is a citizen of the United States, and has a valid tax identification number or a valid Social Security number may open 529 plans.
Can you use 529 for private school?
Yes. The option to use a 529 plan for paying tuition for private school became available due to 2017 tax reforms, and became effective starting in 2018. There is a limit of $10,000 per year per plan, covering kindergarten through twelfth grades.
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