Understanding 529 Plans: A Comprehensive Guide to College Savings

Understanding 529 Plans: A Comprehensive Guide to College Savings

May 13, 2024

Summary:

  • 529 Plans are tax-advantaged savings/investment plans for future education expenses.
  • There are many reasons you may want to invest in a 529 plan:
    • Education may be an important value for your family.
    • You want to give your child or grandchild a less burdensome experience pursuing higher education, i.e. limited or no student debt.
    • You want your child or grandchild to have options about where they want to go to college.
    • You want to save and invest funds in a tax efficient investment account.
    • And more!
  • There are two main types of college savings plans:
    • 529 plans: an investment account meant to save and invest funds for the beneficiary’s future education expenses to be used at (generally) any college or university, and can be used for K-12 private education costs.
    • Prepaid tuition plans: Separate from 529 plans, you can purchase college credits today for future use by your beneficiary.
  • All 529 plans are state sponsored, some of which offer state tax deductions and some of which have residency requirements. Investors have options about what state sponsored 529 plan they’d like to utilize.
  • There are limitations on how much you can contribute to any account, what you can invest in, and how frequently you can change those investments.
  • 529 plans are intended to be used to pay for qualifying education expenses only.
  • There are options to still utilize the account if the beneficiary elects not to attend college, such as a rollover to a Roth IRA.


What is a 529 plan?

A 529 plan is a tax-advantaged savings/investment account meant to enable the account owner to save funds for the account beneficiary’s use toward qualifying educational expenses. There are many reasons why you may want to open a 529 account: you may value education in your family, you may hope to limit the amount of debt your beneficiary takes on to pursue higher education, or you may be looking for an efficient way to save and invest assets.

The tax-advantaged aspect of 529 plans means that earnings grow tax free and distributions are not taxed when used for qualifying expenses – more on what makes for a qualifying expense below.

The owner of a 529 plan is who controls the account, while they usually are the one that contributes the funds for the account, other people can as well. The elected beneficiary is who can utilize the funds for education expenses. Most often we see parents and grandparents setting up accounts for their children and grandchildren, but anybody can be your beneficiary regardless of relationship. The owner of the account can even be the beneficiary!


529 Plans vs. Prepaid Tuition Plans

A 529 plan: A 529 plan is an investment account created with the goal of funding future education expenses. 529 plan assets are typically permitted to be used at any university, college, or trade school – even internationally.

These assets can be used to pay for:

  • Tuition,
  • Required books and supplies.
  • Room and board.
  • Computers
  • Required software.
  • Internet access.
  • And more!

These assets can also be used for student loan repayment up to $10,000. 529 plan assets cannot be used to pay for travel costs, health insurance, or college applications and testing fees1.

Prepaid Tuition Plan:  Another option for funding college for your beneficiary(s) is by way of a prepaid tuition plan. Prepaid tuition plans are not 529 plans or investment accounts, but they allow you to purchase college credits at today’s prices for your beneficiary to use at a future date. You cannot use a prepaid tuition plan to pay for expenses other than college credits, and the credits can only be applied to participating educational institutions. In Washington state, the available prepaid tuition plan is called GET2, and most states offer similar programs.

Both types of plans have associated fees and costs, so it’s important to understand those when deciding what plan to utilize.

State Sponsorship

All 529 plans are sponsored by state governments, some of which have residency requirements and some of which offer state tax deductions. Whether or not your state’s plan has residency requirements or offers a tax deduction will play a role when deciding which state plan to invest in3. For example, Washington state doesn’t offer a tax deduction so if you are a Washington state resident you might shop other state plans (that don’t have residency requirements) that offer more suitable investment options, such as Utah or Virginia. Remember, which state plan you utilize does not limit the state in which the beneficiary can attend college.


Speaking of Investments…

…each state’s 529 plan offers specific investment options to choose from and comes with its own rules about how often you can change your investments. For example, in Washington state you can change your investments twice per calendar year.

There is no annual contribution limit for a 529 plan, and the aggregate limit per beneficiary is very high, though it varies by state. For example, in Washington state, the aggregate limit is $500,000 per beneficiary! Of course, funding a 529 account is considered gifting and any amount contributed over $18,000 in one year to an individual beneficiary is subject to the gift tax4.  But 529 plans also offer the potential to utilize 5-year gift tax averaging, which may come with income and estate tax benefits for those with a significant assets5. This can get complicated quickly, so we are here to help talk it out.

You also might have questions about how to calculate the amount you should save. Our team here at West Invest can help you out with this6!

What if my Beneficiary Doesn’t go to College, Received Scholarships, Dropped out…?

If you’ve funded a 529 plan and your beneficiary doesn’t end up needed to use some or all of the funds, you have options.

Beneficiary Change: One option is to change the beneficiary on the 529 account to somebody who will utilize the funds. You can do so at any time.

Roth IRA: If you’d like to keep the beneficiary, you have the option to rollover the 529 plan to a Roth IRA in the beneficiary’s name. This is a new rule that when into effect January 1, 2024 and there are some stipulations to this option7:

  • The total rollover limit is $35k
  • Annual contribution limits apply
  • 529 account must have been open for 15+ years
  • Funds rolled over must have been in the 529 plan for 5+ years
  • The beneficiary needs to have earned income that matches or exceeds the amount transferred to the IRA from the 529 plan in any given year.

Withdraw the funds: You also have the option of withdrawing the funds for non-qualified expenses. If you do, you will have to pay a 10% IRS penalty, and you will have to pay taxes on the gains of the account. Example:

There are particular scenarios in which you can take a non-qualified withdrawal without paying a penalty8. Some of these scenarios are if a beneficiary passes away, becomes disabled, or attends a U.S. Military Academy. And if your beneficiary receives a scholarship, you can withdraw up to the equivalent of the scholarship from your 529 plan and spend it on anything you want! But it’s important to note, that even though you wouldn’t have to pay the 10% penalty in the aforementioned situations, you would still have to pay income tax on the account earnings.

 

Case Studies

We’ll explain just a few examples of situations people may be in related to 529 plans, and some of the considerations we would discuss in those situations, along with potential outcomes.

Situation #1: Consider a parent who comes to us with an existing 529 account with her child as the beneficiary. While she wants to be able to provide a means to continuing education for her child in the future, she informs us she also has goals to obtain a degree and earn more income. We could discuss the possibility of changing herself to the beneficiary of her existing 529 account. This would alleviate or minimize the cost of school, and once the parent has met her goal she can put her increased income to work in various ways, including restarting to invest for her child’s future education.

Situation #2: A parent lets us know they want to support their child’s goal of pursuing higher education, with the stipulation that the child will contribute as well via loans, income, and/or scholarships. The parent, with the help of the West Invest financial team, calculates how to save approximately 50% of the anticipated education costs for their child via a 529 plan.

Situation #3: A new client comes to West Invest with a well-funded 529 plan. The beneficiary was about to start college but the market was significantly down at the time, and the available funds would only cover expense for 2 years of college. One strategy we could discuss is to wait for the market to recover before taking money out of the 529 plan. One potential outcome of this strategy is that, if the market recovers, the client would ultimately have more money in the 529 account and be able to fund more years of education expenses.

Situation #4: Consider a grandparent who starts a 529 plan for each of their grandchildren, with the goal of fully funding each account to afford the best school in the state. Education is a strong family value and the grandparent feels great!

Resources

  1. Learn more about qualifying expenses.
  2. Washington's GET and DreamAhead 529 Plans - Start saving today.
  3. A Tool for Estimating Tax Benefits of 529 Plans
  4. To learn more about gifting, check out our blog post Building Generational Weatlh: A Strategic Approach to Financial Gifting
  5. Superfunding a 529 plan
  6. How much do I need to save?
  7. Rolling 529 Assets to a Roth IRA.
  8. Learn more about non-qualifying withdrawals that don’t incur a penalty.


Important Disclosures:

Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your advisor prior to investing.