Higher education in the United States has become increasingly expensive, making it challenging for families to secure quality education without taking on substantial financial burdens. As tuition costs continue to rise, the dream of obtaining a college degree is often accompanied by concerns over debt and financial strain.
Funding college education can feel like a monumental task, with families facing decisions about long-term savings, scholarships, and financial aid options. To alleviate some of these worries, financial tools like the 529 plan have been developed to help families systematically save for college and benefit from tax advantages along the way.
What are 529-plans?
Named after Section 529 of the Internal Revenue Code, 529 plans were initially designed to assist families in saving for postsecondary education expenses. Over the past decade, their scope has expanded significantly, allowing these plans to cover not only college but also K–12 education, apprenticeship programs, and student loan repayment. Additionally, the Setting Every Community Up for Retirement Enhancement (SECURE) Acts of 2019 and 2022 introduced benefits like rolling over unused funds into a Roth IRA, making these plans even more versatile.
A 529 plan is a state-sponsored, tax-advantaged account with two main types: Education Savings Plans and Prepaid Tuition Plans.
Education savings plans
Education Savings Plans work similarly to investment accounts. Account holders make contributions, which are then invested in options like mutual funds. Over time, these investments grow tax-deferred, and withdrawals are tax-free when used for qualified education expenses, including tuition, room and board, and certain educational supplies. Donors, typically parents or grandparents, retain control over the account.
Prepaid tuition plans
Prepaid Tuition Plans allow families to “lock in” current tuition rates for future use. While less common than savings plans, prepaid tuition plans can be valuable for families concerned about rising tuition costs. However, these plans are limited to certain participating colleges, and unlike Education Savings Plans, they don’t cover room and board expenses.
529 plans offer flexibility
When a child decides not to attend college, funds can be transferred to another family member or used for other educational expenses, such as apprenticeships or student loan repayment. While there are no annual contribution limits, some states cap the maximum total in a 529 account, typically ranging from $235,000 to $575,000, depending on the state.
529 Plans offer a number of tax advantages
One of the appeals of 529 plans lies in their tax advantages:
Tax-Free Growth : Contributions grow tax-deferred, meaning earnings are not subject to federal or state income tax if withdrawn for qualified expenses.- State Tax Benefits: In some states, contributors can also benefit from state tax deductions or credits. However, tax benefits vary widely by state, so it’s essential to review state-specific rules.
- Gift Tax Exemption: Contributions up to the annual gift tax exclusion amount (in 2024, $18,000) can be made without incurring federal gift tax. Additionally, individuals can contribute up to five years’ worth of gift tax exclusions in one year, allowing for a one-time contribution of up to $90,000 per beneficiary without triggering the gift tax.
While contributions to a 529 plan are not deductible from federal income taxes, these state-level advantages can significantly reduce tax burdens for contributors. If funds are used for non-qualified expenses, however, earnings are subject to taxes and a 10% penalty.
What are some common myths surrounding 529 plans?
Although 529 plans offer substantial benefits, several misconceptions prevent families from fully understanding and utilizing these accounts. Here are some prevalent myths—and the facts behind them.
Myth: ‘Free college’ programs and scholarships mean I don’t need a 529 plan.
Reality: While scholarships and state-funded programs are incredibly helpful, they typically cover only tuition costs and not additional expenses like room and board, textbooks, and supplies. By contrast, tax-free withdrawals from a 529 plan can help cover these additional costs, which can be significant. For example, at public universities, non-tuition expenses often account for more than half of the annual cost of attendance.
Myth: If my child doesn’t go to college, I’ll lose the money.
Reality: If the original beneficiary decides not to attend college, the funds in a 529 plan aren’t wasted. Account holders have options, such as changing the beneficiary to another family member or using the funds for other education expenses like apprenticeships or student loan repayment (up to $10,000). Unused funds can even be rolled over to a Roth IRA under certain conditions, allowing them to support retirement savings instead.
Myth: I can only use a 529 plan in my state or at in-state colleges.
Reality: While many people assume they must use their state’s plan, families are free to choose any 529 plan, regardless of residency. Funds can typically be used at any eligible educational institution in the U.S. and some abroad, covering both in-state and out-of-state costs.
Myth: 529 plans only cover tuition.
Reality: 529 plans are flexible, covering a wide range of educational expenses. Qualified expenses include room and board, fees, books, required equipment (like computers for coursework), and even internet service if needed for classes. Additionally, the SECURE Act has expanded these plans to cover expenses associated with apprenticeships and, under specific conditions, student loan repayment.
Myth: It’s too late to start a 529 plan if my child is nearing college age.
Reality: Starting a 529 plan can still be beneficial, even if college is only a few years away. Contributions continue to grow tax-free, and some states offer immediate tax benefits on contributions. Additionally, these accounts can continue to support a child’s education if they pursue graduate school, allowing families to save for longer-term educational goals.
Myth: 529 plans are just for parents.
Reality: While parents commonly open 529 plans, anyone can contribute, including grandparents, other relatives, and even family friends. These contributions can help relieve some of the financial burdens from parents and provide a broader support system for educational savings.
Myth: If I don’t use my state’s 529 plan, I won’t get any tax benefits.
Reality: While many states offer tax benefits only to residents investing in their home state’s 529 plan, this isn’t universal. A handful of states allow deductions for contributions to any state’s 529 plan, providing greater flexibility. It’s worth researching these options to make the most of available tax benefits.
