An Introduction to 529 Savings Plans
While there are many advantages generally associated with 529 savings plans, they provide two significant federal income tax advantages: tax-deferred growth and tax-free withdrawals if used for qualified education expenses. It’s important to note that while state income tax rules generally follow favorable federal tax treatment, there are some states that tax residents on earnings from out-of-state plans, so it’s best to check with your specific plan.
Here is a practical example of how parents of a newborn might use a 529 plan to save for college expenses. Parents of Destiny, a newborn baby, open a 529 account and contribute $200 monthly over the course of 18 years. Assuming a 6% rate of return, an investment of $43,200 over 18 years would grow to over $77,000 by the time Destiny enters college at age 18. With the ability to avoid both federal and state taxes, the 529 plan would allow Destiny’s parents to eliminate taxes on $33,800 of investment earnings ($77,000 balance - $43,200 total contributions) to use on higher education.
Qualified higher education expenses include the following:
- Tuition, fees, books, supplies, and equipment required for a designated beneficiary’s enrollment or attendance at an eligible educational institution.
- For an eligible student (enrolled at least half-time) for any academic period, the reasonable costs for that period incurred by the designated beneficiary for room and board while attending the institution.
- For a special needs beneficiary, expenses for special needs services that are incurred in connection with the beneficiary’s enrollment or attendance at the institution.
- Expenses for the purchase of computer or peripheral equipment, computer software, or internet access or related services if the equipment, software, or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution.
- Expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school; the amount of cash distributions from all qualified plans with respect to a beneficiary during any tax year can’t, in aggregate, include more than $10,000.
- Fees, books, supplies, and equipment required for a designated beneficiary’s participation in an apprenticeship program that is registered and certified with the Secretary of Labor under Section 1 of the National Apprenticeship Act.
- Amounts paid as principal or interest on a qualified education loan of the designated beneficiary or a sibling of the designated beneficiary.
Additional advantages of a 529 savings plan include:
- Low maintenance – Many plans allow you to select an automatic investment plan so you don’t have to remember to contribute to the plan or reallocate the investments.
- Favorable financial aid treatment – When a dependent student’s parent or a dependent student owns a 529 savings plan, it’s reported as a parental asset and has a relatively minimal effect on financial aid eligibility. Distributions from parent- and student-owned accounts aren’t counted as income on the Free Application for Federal Student Aid.
- Owner control – The 529 savings plan account owner has legal control of the account funds and can distribute the money as needed to ensure the beneficiary isn’t using the funds for nonqualified expenses.
- No income restrictions – You can invest in a 529 plan regardless of how much you ear. Plus, there is usually no minimum to get started.
What if I overfund the account?
It’s important to note that you can withdraw funds penalty-free to the extent the beneficiary’s expenses were reduced due to education tax credits, amount of scholarships, veteran’s education benefits, or other tax-free payments of expenses. You also may withdraw funds penalty-free if the beneficiary goes into the military, becomes disabled, or passes away. In addition, 529 savings plans can generally be used at vocational or other post-secondary institutions in the U.S. as well as many foreign institutions.
While a 529 savings plan can stay active for the life of the beneficiary, you may find that the beneficiary will never use the funds that have accumulated within the account, but you don’t want to pull the funds and pay taxes and/or a penalty fee (you can pull the funds with a 10 percent penalty tax and distributions are includible in gross income). A simple way to avoid those consequences is to transfer the 529 savings plan into another beneficiary’s name. If the new beneficiary is a family member of the account owner, there will be no tax implications.
As with any of these planning techniques, please consult one of our team members to see how it affects your specific situation.
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