How Does A 529 Plan Work?

The 529 plan is a type of savings account that’s designed to save money specifically to pay for education. The biggest benefit of this plan is that it offers tax breaks if the money is used for qualified expenses. Here’s how a 529 savings plan works and the pros and cons of this plan.

A family discussing 529 saving plans

What is a 529 Plan?

A 529 plan is a specific type of tax-advantaged savings plan. It is unlike most other savings accounts that you may be familiar with.

Every 529 plan account has an account owner and a beneficiary. Usually, parents open a 529 savings account for each of their kids. The parent must open a separate account for each child. In this case, the parent is the account holder and the child is the designated beneficiary.

The account owner of a 529 plan doesn’t necessarily have to be a parent. It can be a grandparent or any relative or even a non-relative. On opening the account, the account holder must designate one beneficiary. Every account can have only one holder and one beneficiary. The account holder controls the assets but anyone else can contribute to an already established 529 account.

The aim is to save money to pay for education. When the money from a 529 plan is used for qualified expenses, it does not attract any taxes. Qualified expenses include all expenses related to tuition, fees, books, room, board, and other education-related supplies.

Earlier this was only applicable for college expenses. Very recently it was amended to also include K – 12 tuition with a few restrictions. The amount that can be withdrawn per year tax-free for qualified K-12 expenses is limited to $10,000.

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Why Choose 529 Plans? 10 Compelling Reasons

529 plan offers several compelling benefits that make them a great saving tool.

#1. Tax-free growth for education

Any money that you invest in a 529 plan grows tax-free. No other savings plan offers this benefit. You can deposit money on an after-tax basis into the account and it will grow tax-free. You won’t pay taxes on the gains as long as you use the money for qualified expenses. Qualified expenses include college tuition and fees, room and board, vocational school, and K-12 tuition. Money used for non-qualified expenses will attract a penalty.

#2. Potential state tax breaks

Some states offer tax benefits such as tax deductions or tax credits for contributions to 529 plans. These benefits vary among states and some states don’t offer any tax breaks at all. But you can open a 529 account in any state even if you’re not a resident. Do your research and look for a plan that is best-suited to your financial goals and circumstances.

#3. A wide range of investment opportunities

Every plan offers a range of investment opportunities. These opportunities vary from one state to another. Some plans offer you the option to invest in stock funds. Others may offer other market-based investment options. These investment opportunities range from low-risk-low-return opportunities to high-risk-high-return opportunities. This gives you the ability to earn very high returns on your contributions. At the very least, the savings will be much higher than what any bank savings account offers.

#4. Investment flexibility

If your investment isn’t performing as well as you hoped, you’re not stuck with it. You can change your investment plan options up to twice per calendar year. It’s a good idea to choose a mix of low and high investment opportunities at the start. Track them and see how they are performing regularly. Take the opportunity to switch investments twice a year to maximize your earnings.

#5. Prepaid tuition option

Several states offer a prepaid tuition option. With this option, you save for future tuition at the current cost. This plan protects you from inflation and tuition price hikes. The requirements and conditions for opening a prepaid tuition plan vary among states. Make sure you read the criteria and restrictions before opening this type of account.

#6. Beneficiary can be changed

It happens. Your appointed beneficiary may have made career plans that don’t involve going to college. If your child decides not to go to college, you can name your next child as the beneficiary without a tax penalty. This ensures that your entire fund remains intact and you don’t lose your savings towards taxes.

If the beneficiary is your only child, you can appoint somebody else who is not a family member. The only requirements are that this person must be an U.S. citizen with a Social Security number. You won’t pay any taxes if you use the money for the beneficiary’s education expenses. You can even name yourself as the beneficiary if you intend to return to college.

#7. Flexibility of use

529 plans were originally intended to save for university education. But it was expanded in 2017 to include a wide range of education expenses. You can take advantage of a 529 if you’re paying your child’s tuition for grades K-12. The funds can also be used at qualifying trade schools, apprenticeship programs, and continuing education programs.

#8. No age or income criteria 

There are no age or income to open a 529 plan. Once you open an account, there are no minimum or maximum annual contribution limits. So you can save as little or as much as you can depending on your financial circumstances. This is unlike other savings account such as Roth IRAs or Coverdell Education Savings Accounts. Some states may have lifetime contributions limits though so make sure to read through the conditions carefully.

#9. Funds can be used to repay student loans

In 2019, the 529 plan was expanded and made more flexibility. According to the new additions, the beneficiary can use a 529 plan to pay off up to $10,000 in student loans. They can even use it to pay off up to $10,000 in student loans for each of their siblings.

#10. Simplified tax reporting

You don’t have to report 529 contributions on your federal tax return. In addition, you won’t receive a Form 1099 for reporting taxable or nontaxable earnings. You’ll only receive these forms in the year that you withdraw funds from the account.

Pros & Cons of 529 College Savings Plans

Here’s a recap of the pros of 529 college savings plans:

  • Tax-free growth- any money you invest grows tax-free
  • Tax-free withdrawals if funds used for qualified education expenses
  • State tax breaks
  • No age, income or annual contribution limits
  • Changing beneficiaries is easy
  • A range of mid to high investment opportunities
  • Beneficiary can be changed without any penalties
  • Investment plans can be changes twice per calendar year
  • Up to $10,000 can be used to pay off student loans

Cons of 529 College Savings Plans

The biggest downside is that you only enjoy tax breaks when you use the funds for qualified education expenses. Withdrawals will be taxed if the funds are used for other purposes. Withdrawals for non-qualified expenses may also be subject to a 10% penalty.

529 Plan Alternatives To Consider

Although a 529 plan offers a range of benefits, it may not be the best fit for every family. If you’re looking for alternatives to save for college, consider these options:

  1. Coverdell Education Savings Accounts
  2. UGMA/UTMA Accounts
  3. Roth IRA
  4. Education Tax Credits
  5. Brokerage account

FAQs

What happens if the beneficiary doesn’t go to college?

You can appoint another child as beneficiary if your designated beneficiary chooses not to go to college. Alternately, you can appoint a non-family member as the beneficiary to your savings plan. This ensures that you still get the tax benefits of the 529.

What happens if you use the money for non-qualified expenses?

Maybe your children have no plans to attend college and you don’t know anybody else. You can use the money for some other purpose or even toward your retirement savings. However, if the money is not used for college, you will have to pay a 10% penalty fee and back income taxes on any money that you withdraw. This is to dissuade people from taking advantage of the 520 plan to evade taxes.

Now that you know how a 529 plan works, is it right for you? These plans are very popular for a reason, but they still require some forethought and planning. Want additional information? Check out SEC.gov for more!

Even with proper planning, many families must turn to taking out student loans to help cover college costs. If that’s the case, you’ll need to find a student loan that fits your needs. Check out our free Student Loan Finder to compare lenders and rates side by side.

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