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 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 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. So 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 pro to 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 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.

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.

However, if anyone else decides to open a 529 account on behalf of a child, then any distributions from that 529 are considered part of the child’s nontaxable income and would have to be reported as such on the FAFSA in two years. (The FAFSA looks at income from 2 years prior, so the FAFSA for the 2019 to 2020 school year would consider nontaxable income received in 2017.)

Student income is a major factor in determining financial aid packages, so well-meaning grandparents, aunts, uncles or other relatives who were thinking about opening a 529 for their loved one may want to consider just making contributions to a parent’s 529 instead.

Alternatively, you could wait until January 1 or later of your college sophomore’s second semester to withdraw funds for them to use, since those disbursements would no longer apply on a FAFSA application (assuming that the student finishes school in four years).

3. KNOW WHAT IS CONSIDERED A ‘QUALIFIED EXPENSE’

Funds withdrawn from a 529 plan must be used to cover qualified education expenses, or else you’ll have to pay taxes on the earnings portion of that money, plus penalties. And 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 coed back and forth during 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 cost, or the actual amount that is invoiced for room and board (if the student lives on campus).

Student loan repayment? It would only be considered a qualified education expense if the 529 disbursement was used to pay off the student loan in the exact same year you took the loan out to help pay for education expenses. Once that year is up, then the loan repayment no longer qualifies.

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.

One note: The passage of the Tax Cuts and Jobs Act introduced a key change to 529 plans: You can now use up to $10,000 a year to cover private-school tuition for grades kindergarten through 12. However, at this level, only tuition is eligible — other related educational expenses are not.

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. Currently, you can gift to an individual up to $15,000 if you’re single, or $30,000 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 $75,000 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.

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.

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