May 29th is 529 Day! If you don't know what a 529 plan is, you'll soon find out why they're worth celebrating--especially if you want to put your children, your spouse, or yourself through school.
BREAKING NEWS FOR OKLAHOMA RESIDENTS: The Oklahoma529 plan is offering a $50 or $100 bonus for new 529 accounts until June 9, 2024! See this page for details.
What is a 529 plan?
As the cost of higher education rises and many Americans are mired in student debt long after walking the stage, some are turning to tax-advantaged 529 plans to help fund their family's educational goals. 529 plans are sponsored and run by the 50 states and the District of Columbia, and the rules and fees differ from state to state. You can use a 529 plan to pay for qualified educational costs at any eligible institution (including over 6,000 U.S. colleges and universities and over 400 international schools).
529 plans are investment accounts offering tax-free withdrawals and other benefits when used to pay qualified education expenses. Originally designed to cover postsecondary education costs, their scope has greatly expanded in the last decade. In most states, they can now be used to pay for college, K-12 tuition (up to $10,000 annually), trade schools, apprenticeship programs, and even student loan repayments (up to a lifetime limit of $10,000). Additionally, up to $35,000 of leftover funds in a 529 account can be rolled into a Roth IRA, provided the account is at least 15 years old.
While there are no annual contribution limits, one should consider gift tax implications (more information below). Each state does have an aggregate contribution limit for 529 plans, ranging from $235,000 to over $550,000.
529 plans can be purchased directly through state platforms or from a licensed financial advisor.
Types of 529 Plans
Education Savings Plans: Mostly known as 529 savings plans, these function like investment accounts where contributions grow tax-free and can be withdrawn tax-free for qualified educational expenses (including tuition, fees, room and board, etc.). After-tax contributions are invested in mutual funds or similar investments, so the plan account may vary based on investment performance. Many 529 savings plans offer target-date funds, which automatically adjust over time, becoming more conservative as the beneficiary nears college age. Static portfolios are also typically available, which remain the same over the life of the plan unless the plan owner manually makes changes. These plans are under the control of the account owner.
Prepaid Tuition Plans: These plans enable account owners to lock in current tuition rates for future attendance at selected colleges and universities. Prepaid tuition plans are offered by a few states and some higher education institutions. They vary per plan but like 529 savings plans, eventual withdrawals used to pay tuition are not taxable. However, unlike savings plans, prepaid tuition plans don’t cover the costs of room and board and are not available for K–12 education or trade/apprenticeship programs. In addition, the money paid into a prepaid tuition plan isn't guaranteed by the federal government and may not be guaranteed by states.
Of the two types of plans, 529 savings plans are more common and have benefits lacking in prepaid tuition plans, so we’ll focus on them here.
Tax Advantages
The tax benefits make 529 plans more valuable for college savings than traditional savings or investment accounts. Provided the money is used for qualified educational expenses, 529 plans offer the federal tax benefits outlined above, and may offer state tax benefits depending on the state where the account owner or donor lives. While contributions to a 529 plan are not deductible from federal income taxes, more than 30 states provide tax deductions or credits on contributions, provided you invest in your home state's plan. Additionally, nine states (Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio, and Pennsylvania) offer tax parity, meaning that investors can deduct their taxable income on contributions made to any plan in the United States. Other states will allow you to invest in their plans as a nonresident if you're willing to forgo state tax breaks.
Some caveats: qualified 529 plan withdrawals must happen in the same tax year as the expenses incurred. Non-qualified withdrawals are subject to taxes plus a 10% penalty on the earnings portion of the distribution, with exceptions for certain circumstances (such as death or disability). Common expenses that are considered non-qualified include transportation and travel costs, college application and testing fees, and extracurricular activities.
Gift Tax Implications
Some families use 529 plans in estate planning as up to $18,000 per donor, per beneficiary, qualifies for the annual gift tax exclusion in 2024. However, a donor can contribute up to five years' worth of annual gift tax exclusions in a single lump sum without triggering gift tax consequences, provided they don't make any additional contributions to the same beneficiary over the next five years.
Withdrawing Funds to Pay for Qualified Expenses
Most plans will allow you to distribute the payments directly to the account holder, the beneficiary, or the school. You should check with plans you are considering to determine how they manage distributions.
Other Considerations
- You should review the fees and expenses charged by a plan and how those compare to other plans.
- Anyone can open a 529 account. Parents or grandparents typically establish them on behalf of a child or grandchild, but students can open a 529 plan for themselves if they’re 18 years of age. Your beneficiary doesn't even have to know about the account unless you tell them!
- Each plan can only have one beneficiary at a time, though you can change beneficiaries to another qualified relative (e.g. if one child elects not to go to college, but another does).
- A beneficiary can be anyone of any age, provided they have a social security number or Tax ID.
- Many states have no minimum amount required when contributing to your account; others have relatively low minimums. Automatic contributions can also be set up, with typical minimums of $15 or $25 per contribution.
- You may need to report 529 plan activity (contributions to or withdrawals from) on your annual tax return.
Pros and Cons of 529 Plans
Beyond the tax advantages, benefits include high contribution limits and minimal impact on financial aid, whether the account is owned by the student or the parent. There is also the gift tax exclusion and the ability to front-load a donation with five years’ worth of annual gift tax exclusions in a single lump sum. 529 savings plans are easy to open and maintain, and flexible regarding where they are housed.
Cons include the potential for taxes and fees on non-qualified distributions. There are also limited investment options compared with typical brokerage accounts. While many families don't run up against this issue, some states cap the total amount that can be contributed into the account. 529 plans have fees, though there are many low-cost options. Prepaid tuition plans have the obvious drawback of limiting the beneficiary's choice of educational institution.
The Bottom Line
529 savings plans are truly the gold standard when it comes to saving for educational expenses and have become much more flexible over the past several years. Selecting and maintaining a 529 plan are both relatively straightforward, so 529 plans should be a top consideration for families looking to secure their loved ones’ educational future. Contact your advisor at Oklahoma Financial Center if you need guidance.
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