Set up by state governments, 529 plans could be the best way for parents and others to save for higher education. The plan offers a host of benefits for savers, including tax savings and estate planning. For those saving for college, a 529 plan should definitely have a place on your list.
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The plan is sponsored by various states and comes in two flavors: investment accounts and pre-paid or guaranteed tuition plans. Guaranteed plans allow for investors to buy a future dollars’ worth of tuition expense for less money today, while investment plans function more like a retirement account and own various ETFs and mutual funds in their various subaccounts.
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As we said in the opening, qualified withdrawals can be made tax-free and investment gains/dividends are allowed to compound tax-deferred.
But there is an added tax benefit. Over 30 states currently offer a full or partial tax deduction or credit for 529 plan contributions. By contributing to a plan – typically, your own state’s plan – savers can reduce what they owe each year in state taxes. And, in some states, the reduction is significant, often dollar for dollar. Moreover, recent changes have allowed parents to use the 529 plan for kindergarten through 12th-grade tuition at private schools – up to $10,000 per year.
Check out our state plans section here to learn more about the rules and regulations pertaining to each U.S. state.
One of the chief benefits of the 529 plan comes down to the fact that the donor/account owner controls the assets. Because of this, account owners are allowed to switch beneficiaries of the plan at will. For example, if you’re saving for child A and they decide not to go to college or there’s left over money in the account after paying for school expenses, you can change the remainder to child B or even yourself.
Secondly, because the owner is in control of the assets, they get to make the decisions on ultimately what to do with those funds. If you really want to buy a boat and raid your grandson’s college fund, you’re free to do so. Although we wouldn’t recommend that as non-qualified withdrawals will incur income tax and an additional 10% penalty tax.
This flexibility and ability to switch beneficiaries play into another major benefit of the 529 plan with regards to estate planning. Contributions to a 529 plan are considered “completed gifts” that remove assets from a taxable estate. Thanks to a provision in the tax code, savers are able to contribute five times the annual gift tax exclusion – $150,000 for couples filing jointly, $75,000 for an individual – per beneficiary. While you should consult your own tax advisor, this huge sum can significantly reduce your taxable estate.
But the estate planning aspects get even better. Given that investors are able to change beneficiaries as well as name successors of the account in the event of a death, families can create a legacy of tax-deferred college savings for future generations. Additionally, investors can place unneeded but required minimum distributions (RMDs) from retirement accounts in a 529 plan in order to continue to shield assets from taxes.
Better Than the Alternatives
Finally, the 529 plan wins on the eligibility/financial aid front as well. Currently, only 5.64% of the assets in a parent-owned 529 plan is factored into the Free Application for Federal Student Aid (FAFSA). This allows students to still qualify for grants, work study programs and low-cost student loans. This is unlike Uniform Gift to Minors Account (UGMA) and Uniform Transfer to Minors Account (UTMA) accounts, which are counted as the student’s assets and directly impact FAFSA calculations. The same can be said for regular brokerage accounts, which come with the added hassle of taxes.
Meanwhile, UGMA, UTMA and Coverdell Education Savings Accounts have distribution timelines, and because they are “owned” by the beneficiaries there’s no guarantee that your child will use the money for education. However, with a 529 plan, you can be rest assured that the money will go towards tuition, off-campus housing up to limits, books, computers/required software, internet services and even special-needs equipment.
Be sure to check 529 Insights section here to learn more about the 529 plan.