What is a 529 Plan|Edvisors

What is a 529 Plan?

By Elaine Rubin

Updated on September 11, 2024

A 529 plan, or college savings plan, helps you save for future education costs for yourself, your child, a family member, or even a friend. These plans offer tax perks, including federal benefits and possible state advantages, depending on your location.

While commonly used to cover higher education expenses, 529 plans can now also cover K-12 education, religious schools, and apprenticeship programs in many states.

If you are looking to open a 529 plan, we break down what you need to know about how the plan works and some of the benefits.

Is a 529 Plan Different than a Prepaid Tuition Plan

Prepaid tuition plans and college savings plans are both types of 529 plans. However, they differ in their purpose and benefits.

A college savings plan offers a tax-advantaged investment opportunity for education costs. By investing after-tax money and benefiting from tax-deferred growth, you can make tax-free withdrawals for qualifying educational expenses. Similar to a Roth IRA, the growth of your investment in a college savings plan depends on how you allocate funds within it, tailored specifically for covering education expenses.

On the other hand, prepaid tuition plans focus on allowing you to pay tuition at current rates for eligible colleges. These plans are offered by some states and are typically used for state institutions, often with residency requirements. There may also be other types of private 529 prepaid tuition plans available that don't have residency requirements and can be used for private universities. For more information on these options, it's recommended to consult with a certified financial planner.

Tax Advantages of a 529 Plan

Essentially, the main benefit of a 529 plan is that you do not need to pay federal taxes on the earnings you gain within the fund if you use the money for qualified education expenses. The contributions you make are after-tax and are not tax deductible. If you are contributing to a college savings plan, the fact that you do not need to pay taxes on current income or capital gains, allows your money to compound faster in the investment account.

When it comes to state tax benefits, you may benefit from tax deductions on your contributions to your 529 plan, as well as state tax exemptions on your withdrawals. This all depends on the state where you live, so you may want to have this discussion with your potential 529 plan company or seek advice from a certified financial planner.

Are 529 Contributions Subject to Gift Tax

Contributions to a 529 plan are considered gifts for tax purposes. So, you want to plan your contributions accordingly. For 2022, gifts totaling $16,000 per individual will qualify for the annual gift tax exclusion, and $32,000 for a joint contribution by a married couple giving jointly. So that basically mean, you as an individual, can gift your child $15,000 and qualify for the gift tax exclusion. However, the $15,000 includes all gifts, not just contributions to a 529 plan. If you go over the gift tax exclusion for the year, you will most likely not be required to pay federal estate or gift tax, yet. The amount in excess will go against your lifetime estate and gift tax exemptions and you will need to report the amount in excess of your annual limit on IRS Form 709 when you file your taxes. You do not need to pay taxes until you surpass your lifetime estate and gift tax exemption, which is $12.06 million per individual for 2022, or $24.12 million per couple. It may seem like this number is a bit higher than it has been in the past, and that’s because this is a temporary exception and only applies to tax years up to 2025. Unless Congress makes these changes permanent, after 2025 the exemption will revert back to the $5.49 million exemption (adjustment for inflation).

You may also have the option for a 5-year election, where you as an individual can contribute up to $80,000 per year in 2022 and have the amount spread over a 5-year period. This is called 5-year gift tax averaging or superfunding. It’s best to work with a financial planner or tax attorney to determine the best way to contribute to a 529 plan.

Setting up a 529 College Savings Plan

When it comes to college savings plans, there really isn’t a time too early or too late to start. Saving money for college in 529 plan for yourself or your child, tends to depend on your situation and when you decide to start saving. We’ve already touched on some of the federal tax benefits, and the fact that some states may have additional tax benefits, which can be a great reason to start saving to pay for higher education expenses.

Some parents start saving when a child is born, but did you know that you do have the option to start saving before you have a child? Essentially if you want to start before you have a child, you would open a 529 plan and list yourself (the parent) as the beneficiary. When your child is born, you can change the beneficiary. In general, you can’t have more than one beneficiary on a 529 plan, but you can change the beneficiary at any time. If you only want to have one 529 plan, you need to come up with a strategy on how you intend to use that money on more than one child. It’s best to discuss your options of having one or more college savings plans with your financial planner.

How to Choose and Open a 529 Plan Account

You have several options when it comes to choosing a 529 plan. Many states offer 529 plan options, but you aren’t limited to just choosing a state plan. There are several types of private 529 plans available. It’s important that you do your research! Look through the different types of plans and start weighing your options. There are a lot of factors to consider, like the age of your child, and what you intend to use the funds for.

To find your state options, check out CollegeSavings.org. Finding a private 529 plan will require some research. You can look at websites like CollegeWell.com (formerly Private College 529) and learn about their offerings. They also offer you an opportunity to speak with their financial advisors.

Contributions – How to Make and How Much to Contribute

There aren’t necessarily annual limits to how much you can contribute from the plans themselves, but you will want to consider our earlier discussion about gift tax. Some states may also have an aggregate limit (total contribution amount) you want to be aware of. Now, should you have a contribution goal before your child heads to college, it may be helpful to discuss what your goal will be with a financial advisor. Since every family financial situation is different, and the costs of college can and likely will change between the time you open the account and your child goes to college, it’s recommended to routinely reevaluate your savings goal.

Will a 529 Plan Affect Financial Aid?

One of the top concerns for families who open a college savings plan is the potential effect this money may have on your child’s financial aid. When it comes to college savings plans, there is a good chance it will be reported as an asset on your child’s FAFSA®.

If the owner of a college savings plan is a parent, regardless if the beneficiary is the student or sibling, it will be reported on a dependent undergraduate student’s FAFSA as a parent asset. And remember, the account will need to be owned by an individual, joint ownership is not an option.
If a college savings plan is owned by a dependent undergraduate student, it will be reported as a parent asset.
If a college savings plan is owned by an independent undergraduate student, the asset is report as a student asset.
If a college savings plan is owned by a grandparent, uncle, cousin, or sibling, it is not reported on the FAFSA, but may be reported on the CSS Profile™. However, if the student completing the FAFSA received funds from a college savings plan, the funds would be considered reportable untaxed income, and would be reported on a future FAFSA.

While it’s important to understand the impact of a college savings plan on your financial aid, you shouldn’t rule out having one set up for your child. If you are hoping to receive the Federal Pell Grant, in order to qualify you need to demonstrate exceptional financial need. If your expected family contribution (the index number calculated based on the information you provided on the FAFSA®) for award year 2022-2023 is $6,207 or more, your full-time undergraduate student will not qualify for any Federal Pell Grant funds.

What is a Qualified Educational Expense

Essentially, you can use your 529 funds on what is known as a qualified educational expense and misusing your funds could result in tax penalties. It’s important to understand how you can use your 529 plan funds to avoid any unnecessary tax penalties, and you need to look at both federal and rules of your state.

In general, the IRS defines qualified education expenses as tuition, required fees, books, computers and internet and room and board at eligible institutions (for students attending at least half time. And there may be further rules that narrow down the way you can use these funds. For example, while room and board is only a qualified education expense if the student is enrolled at last half-time. Even though you plan on using the funds for what you assume to be an appropriate qualified education expense, you want to make sure you meet the eligibility criteria.

In 2017, Congress allowed for 529 plans to be used towards K-12 tuition at private schools. And then later in 2019 Congress allowed for the use of 529 plans to help repay the student loans of the beneficiary and the beneficiary’s siblings. Essentially, up to $10,000 for the beneficiary and $10,000 for each sibling.

What if My Kid Doesn’t Go to College

Your child may decide they do not want to attend college, and you have created and funded 529 plan for them. If you withdraw from the account, you will pay income tax and penalties on the earnings of a non-qualified withdrawal. There are a few exceptions to how you can avoid penalties, for example the beneficiary receives a tax-free scholarship, attends a U.S. Military Academy, or dies or becomes disabled. However, you may still need to pay federal and sometimes state income tax on the earnings portion of the fund.

You do have a few options that can help you avoid paying tax or penalties, but it does require you to keep the funds in a 529 account. You could hold on to the funds in the 529 plan and wait to see if your child changes their mind and decides to go to college later in life. Or if your child received a full ride college scholarship for their undergraduate studies, you can save those funds for graduate study. If you have other children or family members who are pursuing a higher education, you can transfer the beneficiary to another student who will be able to use the funds. You can use the funds yourself if you want to pursue an advanced degree. You can even hold the funds until your child has children, and you can help your grandchild pay for K-12 private school, or college. Another option would be to help pay back up to $10,000 of student loans for the beneficiary or their sibling.