Should You Use a 529 Savings Plan to Save for Education?



The cost of going to college continues to get more expensive every year. According to the College Board, higher education costs increased about 3% from last year and as much as 40% from 2005. For example, the annual cost to attend Harvard University as an undergraduate student was $40,000 in 2005, but now carries a $60,000 price tag.

As a result, it's become more important for families to prioritize saving for their children's education. One particular vehicle that could be advantageous for saving for college is a 529 plan.

”Congress created 529 plans to help families save for college on a tax-advantaged basis,"said John Hupalo, CEO of Invite Education, a company providing information and tools to help families better plan and pay for college. "Today, about 11.4 million people have saved over $220 billion in these plans - sometimes $25 a month starting when their children are very young so the investment can grow tax-free for many years."

A 529 plan gets its "catchy" name from the section in the Internal Revenue Code that authorizes its existence. 529 plans come in two flavors: a prepaid tuition plan and a college savings plan. To determine is the latter is for you, you must take stock of the information presented below.

A 529 Savings Plan Carries A Lot of Flexibility

In general, 529 savings plans are extremely flexible with fewer restrictions than other types of tax-advantaged investment vehicles. For example, most plans allow any U.S. resident at least 18 years of age or older to open a 529 savings plan, and there are no income restrictions for making contributions. In fact, the Obamas have four 529 savings plans, each with balances carrying $50,000 to $100,000, according to the president's financial disclosure forms.

A 529 savings plan can be opened to save for a child, grandchild, younger relative, or even for yourself - there's no age limit for the beneficiary of a 529 savings plan. Even better, you can change the beneficiary on an account at any time for any reason, so if you find that one child doesn't need the funds for college, you have the flexibility to change the beneficiary to another member of the family.

"The donor's ability to switch beneficiaries is a tangible way of ensuring that their goal of supporting family members' college dream is fulfilled," Hupalo added. "If the designated beneficiary decides not to attend college or if money is somehow unused in an account, the donor can still leverage the investment by re-designating the 529 account to another fortunate beneficiary. That's very powerful."

While all states and the District of Columbia have 529 savings plans, residents don't necessarily have to limit themselves to plans in their home state. They can shop around and choose the plan that best suits them. However, as discussed below, many states provide a state tax deduction for contributions, so it's often times beneficial to contribute to your state's plan.

Once enrolled in a particular 529 savings plan, account holders have the option to roll over their proceeds to a different plan once every 12 months. But be careful: if you initially invested in your state's plan and received a state tax deduction, certain states will recapture that tax benefit if your monies are rolled out of the state plan.

Ultimately, funds within your 529 savings plan can be used for qualified expenses at most accredited colleges, graduate schools, professional and trade schools, and foreign schools, as long as the institution is eligible to participate in the student aid program administered by the U.S. Department of Education. You can check if a school is eligible through this handy lookup tool. Qualified expenses generally include tuition, fees, books and supplies, room and board and equipment required by the educational institution.

Tax Benefits of a 529 Savings Plan

Beyond the flexibility, there are other benefits associated with a 529 savings plan:

1. State Tax Deduction for Contributions - Currently, 28 states, including the District of Columbia, offer a state tax deduction for contributions to their particular state plan. Six other states (Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania) offer a state tax deduction for contributions to any 529 savings plan. Lastly, eight states (California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, and North Carolina) have an income tax, but don't offer a deduction for 529 plan contributions. The remaining states don't have a state tax, and thus don't have a state tax deduction to offer.

2. Double-Tax-Advantaged Savings Vehicle - While monies are not contributed on a pre-tax basis for federal income tax purposes, the funds grow tax-deferred, and withdrawals are tax-free as long as they are used for qualified education expenses.

3. Gift Tax Benefits - Unlike other savings and retirement plans, 529 savings plans have an extremely high contribution limit - many state plans have limits in excess of $200,000. Contributions are treated as gifts and traditionally, one can gift $14,000 a year to a recipient without triggering the gift tax or counting against their lifetime gift tax exclusion (currently $5.34 million).

However, 529 savings plans allow you to front-load tax-free contributions for up to five years. What that means is you could contribute up to $70,000 initially per beneficiary ($140,000 for a married couple filing jointly) without triggering a gift tax or chipping away from your lifetime gift tax exclusion.

Don't Get Schooled

While 529 savings plans are extremely flexible and carry advantageous tax benefits, there are penalties if withdrawals are not used for qualified educational expenses. Specifically, the earnings portion of withdrawals that aren't used for qualified expenses will be subject to ordinary income tax (federal), a 10% federal penalty tax and possibly state and local taxes as well.

With that said, "529 savings plans meet the college savings needs of a large majority of families whether they give five years of contributions upfront or they're saving $25 per month," Hupalo concluded. "529 savers are smartly taking advantage of the most flexible tax-advantaged savings program ever created by the U.S. Congress."

Before choosing a particular 529 savings plan, be sure to understand all of the terms, restrictions and fees associated with enrolling in the plan. Once in a plan, determine your contribution strategy and choose investments based on your time horizon and risk tolerance. Lastly, when removing money from a plan, be sure to understand what qualifies as an eligible expense and be mindful of any timing considerations.

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