For many, the three largest life expenses are retirement, home ownership, and funding children’s education. Preparing for college expenses presents some unique challenges. Many parents find college savings somewhat confusing. Additionally, financing college often occurs shortly before retirement, allowing only a slim margin for recovery from poor decisions. But saving for college doesn’t need to be confusing or difficult. There is a tax-favored savings plan designed specifically to help parents prepare for their children’s education. It’s the 529 plan.
Tax-Deferred Education Savings Plans
529 plans allow you to save for future education expenses in a tax-deferred vehicle. Contributions are not tax deductible from federal income tax, but may be deductible from state taxes, but earnings accumulate tax deferred. If the funds are used for a beneficiary’s qualifying education expenses, then there’s no tax on withdrawals.
There are two types of 529 plans: Prepaid Tuition Plans and Education Savings Plans.
Prepaid tuition plans allow you to save some or all of your beneficiary’s tuition – prepaying future expenses at current rates. Most plans allow you to save for a future in-state public education, with a limited ability to use the funds in other states. Some institutions offer their own prepaid plans.
Education or “College” savings plans are offered by states and allow you to save on a tax-favored basis. The funds can be used in any state at most colleges in the U.S. and some outside the country. Education savings plans have far more flexibility than prepaid tuition plans.
Fees and expenses vary by plan. But they are very straightforward. The typical structure is a state plan that may have a state fee. There are also investment management fees. Still, the total cost structure of the typical 529 plan tends to be quite low.
Account Owners and Beneficiaries
Anyone can open a 529 plan. Not only can you open one for your child, but you can open one for anyone else, including yourself. The person who establishes the account is the owner. The person who will use the funds is the beneficiary. These roles have important distinctions.
As the account owner, it’s your money. If there’s a state tax credit or deduction for the contribution, that’s yours. If for some reason the beneficiary doesn’t end up using all the funds, the remainder is yours. This is a significant advantage over education funding options where the beneficiary controls the money.
Most parents are looking to save for their child’s education – not to pay for a new sports car. With a 529 plan, you retain control of the money.
A 529 plan is intended to fund a beneficiary’s education. But you have options if your child doesn’t go to school or if you saved more than they need for college. You can name other beneficiaries, allowing you to fund a different family member’s education.
Other Tax Considerations of 529 Plans
Some states provide a tax credit or deduction for plan contributions. This generally applies only when you use your own state’s 529 plan. However, some states allow you to deduct contributions made to other states’ plans.
Funds not used for education are subject to taxation. There is also a penalty on withdrawals that are not used for qualifying education expenses. This applies to funds withdrawn from an overfunded 529 plan.
Qualified vs. Nonqualified Education Expenses
You get to make tax-free withdrawals only for qualified education expenses. These include tuition and fees, books, and computer equipment and access. Room and board are qualified expenses if the beneficiary is at least a half-time student, even if the housing is off-campus. You can also use 529 plan assets tax free for K-12 tuition.
Everything other than these is nonqualified. Examples include transportation to and from school, health insurance premiums, and fraternity dues.
Financial Aid Considerations
529 plans have another benefit over other college funding options. Assets in a 529 plan are considered parental assets when determining a student’s Expected Family Contribution (EFC). Parental assets have a higher threshold and are considered at a lower rate than the student’s assets. So, a 529 plan typically won’t jeopardize financial aid.
It is important to note that financial aid varies widely among institutions. While a number of schools depend heavily on the EFC, many dig deeper to determine ability to pay. Generally, the more elite schools will do a closer financial examination, although there are exceptions.
Federal rules do not impose a limit on total contributions to a 529 plan, but many states do. Still those contribution limits are quite high because the cost of a college education is expensive. The average total contribution limit is several hundred thousand dollars. In some states, around half a million dollars.
While there is no annual contribution limit, very large contributions may be regarded as taxable gifts. Contributing amounts just under the gift tax exclusion may be optimal for some parents. Parents should always consult their tax advisors regarding gift tax rules.
Even though there is no strict dollar limit, contributions should not exceed what is reasonably necessary for a beneficiary’s education. The role of the 529 plan is to finance education, not avoid taxes. And funds withdrawn from a 529 plan and used for anything other than qualified education expenses are subject to both income tax and penalties.
There is no Time Like the Present
For parents (and grandparents, aunts, uncles, or other relatives) with young children and a desire for them to attend college, there is no better time than right now to begin a college savings program. A 529 plan provides an excellent opportunity to do this.
A 529 plan offers several tax advantages. It provides for tax-deferred growth. Withdrawals used for qualified education expenses are not subject to income tax. And some states offer a tax credit or deduction on contributions.
Contribution limits are generous. In general, the annual gift tax exclusion presents a natural ceiling for many. The 529 plan offers great flexibility. You can roll assets into another plan or change beneficiaries as needed. And plans generally are inexpensive to establish and maintain.
To see current average college tuition costs, and to estimate the savings requirements for your child’s education, see our College Savings Calculator. To set up a 529 plan through Victory Capital call 833.329.0099.