529 plans: what you need to know

Education Book StackKJ: As promised in our post on intro to funding education, below is some more information on what a 529 plan is and the different types. It’s but one account type you can utilize to help fund your children’s education, but they can really be a powerful tool.

Key benefits
A 529 plan is essentially a tax-advantaged way of saving for education, much like what the Roth IRA is for retirement.

The money you save to the account is not deductible for federal income taxes (though it may be for state income taxes if applicable for your state of residence), and earnings/growth in the account is not taxed each year. In fact, provided you use the account for higher education expenses including room & board, tuition, fees, books, etc., then you don’t have to pay any taxes on the growth of the account. Here’s a breakout of what that looks like:

If you put a total of $50,000 into a 529 plan, and it grows over time to $75,000 by the time the child goes to college, then provided you use the entire account for college expenses the $25,000 in growth is not taxed. Had this been in a regular investment account, that same growth could actually be closer to $60,000-70,000 instead of $75,000 when taxes and compounding of tax-free growth are taken into account.

Two types: prepaid tuition plans and savings plans
There are two primary types of 529 plans: prepaid tuition plans and savings plans.

    Prepaid tuition plans
    A prepaid tuition 529 plan allows you to essentially lock in the cost of college today. There aren’t too many of these around anymore, and each one is quite different with respect to age limits, contribution limits, residency requirements, etc. A number of them allow you a “credit” amount if your child happens to go to a school out of state, but these plans are becoming fewer and farther between. Plus, many of them just aren’t quite as beneficial as they used to be.

    Savings plans
    These accounts act just like a regular savings or investment account. You open an account with a state (each state sponsors their own 529 plan, but you don’t have to go to college in that state in order to use it), and you name a “beneficiary” for which the account will be used. Just like researching where to open a savings, bank, or brokerage account, you have many options for a 529 plan too. Since each state sponsors a 529 plan, there are lots of options to think about before opening an account and here are just a few of the considerations:

    Are there any one-time or monthly fees associated with the accounts?
    What are the investment options available? They’re generally limited like a 401(k) plan is.
    How have the age-based investment options performed?
    How easy is it to make transfers when needed?
    How seamless is their website (and does it connect to quicken or Mint.com)?

    Contribution amounts are usually quite large (usually about $300,000 lifetime contributions). However, amounts you contribute to a 529 plan are considered a gift for federal income taxes. As such, for current year contributions, you can contribute up to $14,000 (for 2013) per person per child tax free without triggering gift tax consequences. However, you can also decide to front-load the plan and contribute up to $70,000 and treat it as if it had been gifted over five years (i.e. $70,000 divided by 5 = $14,000).

Who controls the account?
You do! Unlike a lot of accounts out there, you actually retain full control of when to distribute money from the 529 plan even when your child is in college.

What happens if I don’t use all of the funds in an account?
If you have been fortunate enough to save to a 529 plan, paid education expenses, and still have some left over, then don’t panic, because there are still some options available to you. You can change the beneficiary of the account to another child (or other family member as defined by the IRS), or you can even change the beneficiary to yourself and use it for any higher education expenses for your continued education!

However, if you ultimately decide to take money out of the account that isn’t used for higher education expenses, then you have to pay federal income taxes (possibly state taxes too…) and a 10% penalty. Meaning, back to our example of the $75,000 account, if you took out the full amount and didn’t use any of it for higher education, then you would owe taxes on the $25,000 of growth plus a 10% penalty on the $25,000.

Further reading
With as many tax rules as there are about what expenses qualify (though it’s pretty generous), who you can assign as the beneficiary, etc. it may be good to review the IRS website on 529 plans before taking the plunge. Used right, they can be a great tool for accumulating some extra funds for your children for college, but it’s important to understand the characteristics of the accounts, so you know what you’re signing yourself up for. The tax-exempt nature of the accounts can give you more bang for your buck, and who doesn’t like that!?

    Have you opened a 529 plan for your child(ren)?
    What do you like (or dislike) about the accounts?
    Tell us how you made the decision.

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