As the cost of higher education continues to rise and many Americans face prolonged student debt, tax-advantaged 529 savings plans have become a vital tool for funding education. Named after Section 529 of the Internal Revenue Code, these plans were originally designed to cover postsecondary education costs. However, their scope has expanded significantly over the past decade.
In 2017 and 2019, Congress passed legislation allowing 529 plans to cover K-12 education and apprenticeship programs. Later, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 and the SECURE 2.0 Act of 2022 permitted 529 funds to be used for student loan repayment and Roth IRA contributions.
There are two main types of 529 plans: Educational Savings Plans and Prepaid Tuition Plans. Let’s dive deeper.
Types of 529 Plans
Education Savings Plans
Education savings plans offer tax-deferred growth, and withdrawals are tax-free when used for qualified education expenses. These plans are actively managed and primarily invested in mutual funds and ETFs. Account holders have the flexibility to choose investments, frequently gravitating towards target-date funds that adjust asset allocation as the beneficiary approaches college age.
These funds cover various qualified expenses, including tuition, fees, room and board, and related costs. Legislation has also expanded qualified expenses to registered apprenticeship programs and allows up to $10,000 for student loan debt repayment.
Prepaid Tuition Plans
Prepaid tuition plans are less common but beneficial in locking current tuition rates for future college attendance. Offered by a few states and some higher education institutions, these plans cover only tuition and mandatory fees. Prepaid plans cannot be used for room and board expenses.
Unlike savings plans, the funds in prepaid tuition plans are not guaranteed by the federal government. It is essential to understand the specifics and limitations of the prepaid tuition plan you are considering.
Key Benefits of 529 Plans
- Tax-Deferred Growth: Contributions grow tax-deferred, and withdrawals are tax-free when used for qualified expenses.
- High Contribution Limits: States set high lifetime limits, ranging between $235,000 and $575,000.
- Transferable Benefits: Funds can be transferred to another qualifying family member without tax penalties.
- Flexible Usage: 529 plans cover education costs from kindergarten through graduate school, including apprenticeship programs.
- State Tax Deductions: Many states offer partial state income tax deductions or credits for contributions.
Potential Drawbacks of 529 Plans
- Limited Investment Options: Investment choices are curated and may not offer the diversification benefits of a standard brokerage account.
- Fee Variability: Administration and asset management fees can differ widely between states and providers.
- Education-Specific Usage: Withdrawals for non-qualified expenses are subject to taxes and penalties.
Comparing 529 Plans with Brokerage Accounts
529 Plans
- Tailored for education savings
- State or institution-sponsored
- Limited investment options with tax benefits
- Tax-deferred growth and withdrawals
Brokerage Accounts
- General-purpose investment accounts
- Self-managed with diverse investment options
- No tax advantages for education-specific savings
- No contribution limits or tax-free withdrawals
Gift Tax Implications
The annual gift tax exclusion in 2024 is $18,000, meaning you can contribute up to five years’ worth of this exclusion in a lump sum without triggering gift tax consequences. For example, a grandparent could contribute up to $90,000 to a 529 plan in a single year.
Managing Leftover 529 Funds
With legislative changes allowing partial rollovers into Roth IRAs, you have additional flexibility in managing unspent funds if the beneficiary does not use all the money for educational purposes.
Conclusion
Creating a 529 plan is a proactive and tax-efficient strategy for meeting future educational expenses. With options to cover K-12 and apprenticeship programs and even facilitate student loan repayment, these plans are versatile and beneficial for long-term financial planning. By starting early and understanding your state’s specific rules, you can ensure your investment grows efficiently to meet the educational needs of your child or grandchild.
Related Terms: Roth IRA, Brokerage Account, Gift Tax, Tax Deduction, Student Loan.
References
- Internal Revenue Service. “Publication 970 (2023), Tax Benefits for Education”.
- U.S. Congress. “SECURE 2.0 of 2022 Act”.
- U.S. Congress. “H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019”, Sec. 302.
- Internal Revenue Service. “TG 44: Qualified Tuition Programs.”
- U.S. Securities and Exchange Commission. “An Introduction to 529 Plans.”
- Education Data Initiative. “College Savings Data”.
- National Association of State Treasurers. “College Savings”.
- Internal Revenue Service. “Topic No. 313 Qualified Tuition Programs (QTPs)”.
- U.S. Securities and Exchange Commission. “An Introduction to 529 Plans”.
- Congress.gov. “H.R. 2617 - Consolidated Appropriations Act, 2023”. Division T, Section 126.
- my529. “SECURE Act 2.0”.
- 529 College Savings Plan. “529 Plan Comparison by State”.
- Internal Revenue Service. “Gift Tax”.
- Saving for College. “How Much Is Your State’s 529 Plan Tax Deduction Really Worth?”
- Saving For College. “529 Fee Study”.
- The Wall Street Journal. “The Fees on Your ‘529’ Tuition-Savings Plan Matter More than Ever”.
- U.S. Securities and Exchange Commission. “Investor Bulletin: 10 Questions to Consider Before Opening a 529 Account”.
