529 Plan: What It Is, How It Works, Pros and Cons

A 529 plan is a tax-advantaged savings option designed to help families save money for the costs of their children's future education. States, public organizations, or educational institutions are authorized to provide funding for this plan, which derives its name from Internal Revenue Code Section 529. A 529 plan's main goal is to give people a method to save money for approved educational costs such as tuition, fees, books, and room and board.

The two primary categories of 529 plans include education savings plans and prepaid tuition plans. Participants in prepaid tuition plans can prepay all or a portion of their tuition at approved colleges or universities at today's rates, safeguarding themselves from tuition inflation in the future. Contrarily, education savings plans include a range of investment options, frequently including mutual funds, to aid in the growth of savings over time-based on market performance.

The advantageous tax treatment that 529 plans receive is one of its main benefits. The earnings within the account increase without any tax imposed. Additionally, federal income tax is not applied to withdrawals utilized for eligible educational costs. For people who contribute to their state's 529 plan, several jurisdictions additionally provide additional tax advantages, such as deductions or credits.

It is important to be aware that non-qualified withdrawals from a 529 plan may incur taxes and penalties. A 529 plan's effect on financial aid eligibility should also be taken into account since it is regarded as the account owner's property. Making informed judgments requires having a thorough understanding of the investment possibilities, contribution restrictions, and potential dangers related to a 529 plan.

Investment growth in a 529 plan is tax-deferred until it is taken out. Additionally, as long as the money is spent for acceptable educational costs as defined by the IRS, neither state nor federal taxes are required on those withdrawals. Some states may also provide tax deductions for contributions.

Tax-free withdrawals for K-12 students are capped at $10,000 annually. You must carefully read the details of any 529 plan to determine the precise tax benefits to which you may or may not be entitled because state-specific tax benefits vary from one region to another.

Types of 529 Plans

There are mainly two types of 529 plans which are explained below:

1. Education Savings Plans

The 529 savings plans are the most common type. The owner of the account contributes money to the plan. The money is invested using a predetermined set of investment options. Users of accounts can choose their investment, which is often a mutual fund. How well these assets perform will determine how much the account value rises over time. Target-date funds are often used in 529 plans; they change their holdings over time and become more conservative as the beneficiary approaches college age.

A 529 savings plan withdrawal can be used to pay for K-12 as well as college-related qualified expenses. The following are eligible expenses: tuition, fees, housing & board, and other associated costs. The SECURE Act of 2019 now permits beneficiaries of 529 plans to withdraw money tax-free for expenses related to registered apprenticeship programs and up to $10,000 in student loan debt repayment for themselves as well as their siblings.

Additionally, from January 1, 2024, the SECURE Act of 2022, which was passed as a component of the 2023 Omnibus spending package, will allow the transfer of up to $35,000 in unused 529 plan funds into a Roth IRA account. The account must be at least 15 years old in order to be eligible for this scheme.

2. Prepaid Tuition Plans

Prepaid tuition plans are offered by a few states, as well as numerous colleges and universities. Although the specifics vary, the general concept is the same: you may lock in tuition at current rates for a student who might not join college for years. For K-12 education, there are no prepaid options.

Prepaid tuition programs appreciate in value over time, just as 529 savings plans. Future withdrawals from the account used to pay for tuition are not taxed. However, unlike savings plans, prepaid tuition programs do not include room and board costs. Prepaid tuition plans might only be applicable to a certain group of universities. In contrast, the money in a savings plan can be used at almost any institution that qualifies. Additionally, neither the federal government nor all states may provide a guarantee for the money invested into prepaid tuition plans. Make sure you are familiar with every aspect of the prepaid tuition plan before opting out for one.

Tax Advantages of 529 Plans

The 529 plans are a desirable alternative for saving for educational costs since they provide significant tax advantages. The 529 plan's contributions are made with after-tax money; thus, they are not federally tax deductible. Also, the account's earnings increase tax-free. The money can grow and compound tax-free without having to pay annual taxes on investment gains thanks to this growth. Additionally, withdrawals are completely tax-free when used for eligible educational costs like tuition, fees, books, and room & board. Individuals can access their money in this way without having to pay federal income taxes on their earnings.

The tax benefits that several states offer for contributions to 529 plans are numerous as well. These benefits can include tax deductions or credits for donations made to the state's 529 plan. In many areas, income, and withdrawals used to pay for acceptable educational costs are also excluded from taxes. People should check their particular state's rules and regulations regarding 529 plan tax advantages because the availability and scope of state tax benefits differ.

529 Plan Transferability Rules

The federal tax code's Section 529 specifies transferability regulations that apply to 529 plans.

The owner (suppose you) can only transfer to a different 529 plan once each year if the beneficiary changes have not been made. You don't need to amend your plans in order to change beneficiaries. The Internal Revenue Service (IRS) gives detailed instructions for replacing a 529 savings plan beneficiary, although it's not a particularly difficult procedure. The new designated beneficiary must be a qualified individual, which usually means a member of the recipient's family that includes any of the following:

• son, daughter, stepchild, foster child, adopted child, or a lineal descendant of any of them.
• a sibling, a stepbrother, or a stepsister.
• either the mother or the father, or both.
• a brother or sister's son or daughter.
• sister or brother of the mother or father.
• father-in-law, mother-in-law, brother-in-law, or sister-in-law.
• the spouse of any of the people mentioned above.
• Primary (first) cousin.

Pros and Cons of 529 Plan

When deciding whether to invest in a 529 plan, individuals should consider the following pros and cons:

Pros

• Tax Benefits: One of the main advantages of 529 programs is their tax benefits. Withdrawals for qualified educational expenses are tax-free. Additionally, account gains grow tax-free over time, offering potential long-term savings.
• Flexibility: 529 plans allow for adjustments to beneficiaries, investment options, and plan selection. Participants can pick the best plan for their requirements and change investment methods as needed. Additionally, it is feasible to adjust beneficiaries within the family to accommodate changing educational objectives.
• Large Contribution Limits: Because 529 plans often feature large contribution limits, people can save a lot of money for college. For certain plans, the lifetime contribution cap might be in the thousands of dollars.
• State Tax Benefits: For citizens who contribute to their state's 529 plans, they are often provided with additional tax benefits, such as deductions or credits. These state-specific advantages may boost incentives and lower tax obligations.

Cons

• Investment Choices Are Limited: Although 529 plans provide investment options, they are nonetheless few in comparison to other investment vehicles. Participants may be restricted in their capacity to personalize their investing strategy by having to choose from the options offered by the plan.
• Penalty for Non-Qualified Withdrawals: If money is taken out of a 529 plan and utilized for non-qualified expenses, such as those unrelated to school, taxes and penalties may apply. This fine/ penalty may lower profits and lower the plan's overall benefit. This penalty fee may vary from one state to another.
• Impact on Financial Stability: Because 529 plans are seen as the account owner's assets, the restrictions may have an impact on a beneficiary's ability to receive need-based financial help. Even though the effect is typically minimal, it's vital to be aware of how a 529 plan could affect financial aid calculations.

What is the cost of a 529 Plan?

The States commonly charge a one-time account establishment fee for 529 programs. The cheapest of them has ranged in price from $25 in Florida to $964 in West Virginia.

Furthermore, you might have to pay a charge of up to 5% or more on the assets if you bought your 529 plan through a broker or advisor. For the various investments and funds you have in your 529, there can be ongoing fees as well. Look for cheap (low-cost) mutual funds and ETFs to save management expenses.

Who has supervision of the 529 plan?

The account owners normally retain control over a 529 plan. They have the power to administer the account, make payments, pick investments, and choose how and when to utilize the money for permissible educational costs. The beneficiary may also be changed at any time by the account owner. While the state or educational institution may be involved in the management of the funds in prepaid tuition programs, the account owners still retain authority over beneficiary designation and use of the credits. The account owners must be aware of their obligations if they want to effectively manage the 529 plan.

A 529 plan is a custodial account, and consequently, an adult custodian will administer the funds for the benefit of a juvenile. When the beneficiary turns 18, he/ she can take control of the 529. However, the funds must be used to cover reasonable educational expenses.

What do a 529 Plan's qualified expenses entail?

The following are qualified costs for a 529 plan:

• Tuition and expenses for undergraduate, graduate, and vocational programs.
• Tuition and expenses for elementary or secondary schools (K-12).
• Books and educational materials.
• Repayment of student/ education loans.
• Dwelling away from campus.
• Meals and food on campus.
• Internet, software, and computers used for academic work (student attendance is necessary).
• Students' special requirements and accessibility equipment (related to education).

The Bottom Line

You can save money with tax-advantaged 529 plans for educational costs from pre-kindergarten to graduate school, including apprenticeship programs, and setting up a 529 plan is no hassle. If the 529 account is 15 years or older, there is now a new option to transfer up to $35,000 of unused assets into a Roth IRA account. In this way, these plans provide flexibility and the potential for tax-advantaged growth for your future scholars. A person can open his/ her 529 plan directly with the help of a state or with the help of an authorized broker or financial advisor. There are a wide variety of 529 plans available in most states in the United States.