Your children’s college graduation is one of those life milestones you probably daydream about from the moment they’re born.
But how do you help cover a college price tag that could be six figures by the time they have a diploma in hand? That’s where a 529 college savings plan can help. A 529 savings plan is a type of state-sponsored investment account designed specifically to help save for future educational costs.
There’s a lot that is great about 529 plans, such as the tax advantages they can offer, but if you don’t know all the rules surrounding them it can be easy to make mistakes that could cost you later. So before you open a 529 plan, take note of these important steps.
1. Shop around
Each state plus the District of Columbia sponsors at least one 529 savings plan. But you aren’t limited to choosing the 529 plan for your state, so do some homework to see which seems right for your situation. Some things to consider:
Investment options. When you open a 529 plan, your dollars will be invested in funds offered through a plan manager, and the types of investments offered will vary by provider. Make sure that any plan you look into aligns with your goals, as the performance of your 529 will be based on its underlying investments.
Fees. A 529 plan can be sold directly from the state or through an advisor. You may be charged annual fees, account-opening fees or other types of expenses associated with maintaining your account, so make sure you understand what the total cost will be to you.
State tax breaks. One benefit of opening a 529 plan in your home state is that you may be able to get a break on your state taxes. 529 plans already offer great federal income tax benefits: Earnings grow federal-tax-free, and withdrawals are tax-free if they are used for qualified education expenses. However, more than 30 states also give residents a tax deduction or credit if you contribute to one of their 529 plans.
If you’re looking into a state-sponsored prepaid 529 plan — which helps you pay for future college credits at today’s prices, typically for specific schools in that state — be aware that you may have to be a resident of that state to enroll. There are also other rules around how prepaid 529 funds can be used, so make sure to read the fine print carefully before deciding on one.
2. Learn how 529s affect financial aid
A student’s financial aid can be impacted by who is listed as the owner (or custodian) of a 529 account. Student income is a larger factor in determining financial aid packages than the parents’ assets.
If the custodian is the parent of the beneficiary of the account (i.e., the child who will use the funds), then the money in the 529 plan would be reported as part of the parents’ assets on the FAFSA form. If the custodian is the student but he or she is a dependent of their parents, then that money would still count toward the parents’ assets.
Currently, if anyone else — like a grandparent, aunt, uncle or other relative — decides to open a 529 account on behalf of a child, then any distributions from that 529 are considered cash support and part of the child’s nontaxable income, which is reported on the FAFSA in future years. The good news: Changes to the FAFSA rules starting with the 2024 to 2025 school year will mean students no longer have to report cash support on their FAFSA, so distributions from a non-parent-relative’s 529 plan won’t impact your child’s need-based financial aid.
3. Know what is considered a ‘qualified expense’
Funds withdrawn from a 529 plan must be used to cover qualified education expenses for higher education, or else you’ll have to pay taxes on the earnings portion of that money, plus penalties. (The exception is $10,000 to cover tuition costs only for private or religious elementary through high schools.)
What falls into that definition may not be as expansive as you think. Tuition for instance, is considered a qualified expense, as are books and supplies, along with the laptop your child may need to do their coursework. But costs like campus health insurance or airfare to fly your child home for school breaks is not covered. Room and board is also tricky. If your child is enrolled at least half-time, then those costs can be covered — but only up to what the college lists as its official room and board price, or the actual amount that is invoiced for room and board (if the student lives on campus). Not knowing what’s covered could result in withdrawing more money than you need, which in turn means you could end up paying taxes and penalties on the amount that didn’t go toward qualified expenses.
What about student loan repayment? The SECURE Act signed into law in late 2019 expanded the definition of qualified expenses to include student loan repayment up to a certain amount. The change allows each beneficiary of a 529 plan to use up to $10,000 over their lifetime to pay down student loans (although any student loan interest paid for with 529 earnings can’t be deducted from taxes).
4. Don’t forget about the gift tax exclusion
Contributions to a 529 plan are considered a gift to the beneficiary under IRS rules, which means they can count toward the gift tax exclusion. In 2022, you can gift to an individual up to $16,000 if you’re single, or $32,000 if you’re married, without it counting against your lifetime gift tax exemption.
But there’s also a special rule for 529s specifically that lets you front-load up to five years’ worth of gifts per child. That means for each child’s 529 that you contribute to, you could potentially gift up to $80,000 without having it count against your lifetime gift tax exemption. The catch is that you’d have to wait another five years before you could contribute again, unless you’re willing to use up some of your lifetime gift tax exemption. Knowing this could help you with your long-term tax and estate planning. Additionally, any other gifts you made to that beneficiary outside of the 529 account during those 5 years would have to be applied against your lifetime gift tax exemption.
No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested. This publication is not intended as legal or tax advice. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.