Are future college expenses weighing on your mind?
If so, that makes sense because, according to the Education Data Initiative, the cost of a college degree has more than doubled during the 21st century.
But wait, there’s more:
- The average cost of college in the U.S. is $35,551
- The cost of college has an annual growth rate of 6.8%
- The cost of a bachelor’s degree can exceed $500,000
With skyrocketing education costs, planning for your child’s future is more important than ever. Luckily, 529 Plans are specially designed to make educational funding simple.
Read on to find out if this plan is the right fit for your student.
What’s a 529 Plan?
A 529 Plan is a type of state-sponsored, tax-advantaged account that you can use to cover educational expenses throughout a child’s life.
There are two types: prepaid tuition plans and college savings plans.
Prepaid Tuition Plans
Prepaid tuition plans are the less common of the two. They enable you to purchase credits at a participating public college to cover future tuition expenses.
These accounts tend to have stricter rules for what qualifies as an education expense. They typically do not allow you to prepay for room and board or elementary/secondary schools. Instead, these plans usually only cover the costs of tuition and fees.
Additionally, most prepaid tuition plans have residency requirements for the saver and/or beneficiary.
College Savings Plans
When you think about 529 plans, you’re likely picturing a college savings plan. This plan operates like an investment account, similar to a Roth IRA.
How do they work? You use after-tax dollars to invest in a selection of investments like mutual funds or exchange-traded funds (ETFs). The funds within the account grow tax-free, and distributions for qualified education expenses remain tax-free.
What counts as a qualified expense? The definition is much broader within college savings plans and includes costs like tuition, fees, room and board, and supplies (laptops, books, etc.).
Thanks to the SECURE Act, you can also use up to $10,000 in a 529 Plan for student loan repayment (one-time) and K-12 education expenses (annual limit).
How are 529 Plans Helpful?
With great tax breaks and diverse plan options, it’s no surprise that financial advisors consider 529s an incredible college investment tool.
Federal and State Tax Breaks
You don’t have to pay federal taxes on 529 plan earnings as long as you use those earnings to pay for qualified higher education expenses such as:
- Tuition and fees
- Books and supplies
- Computers, software, and internet access
- Room and board
You can also receive a partial or full tax deduction for 529 contributions depending on your residency and state plan. Kansas, for example, allows its residents to contribute to any state’s 529 plan and still receive the state income tax deduction (not all states are this generous).
Freedom to Choose a Plan From Any State
A unique thing about 529s is their benefits range by state. In addition, you can pick the plan that works best for you, no matter your residency! So if you live in Kansas, you can enroll in Utah’s 529 Plan.
There are more than 100 different 529 plans available to choose from. Individual states set their rules and regulations. Find out more about your state’s laws here.
Flexible Contribution Limits And Unlimited Withdrawals
The IRS institutes a contribution “cap” on most tax-advantaged tools, like an IRA or 401k. But 529 plans don’t have the same strict annual contribution limits.
While you can put as much money into the account as you see fit, keeping the annual gift tax exclusion in mind is essential. In 2022, you can give an individual up to $16,000. The IRS considers anything over that amount a gift, and you’ll need to report it when you file your return in April.
There are a couple of creative ways to avoid the gift tax when saving for college:
- Pay the education institution directly. When you do this, you can sidestep the gift tax limits.
- Front-load 5 years’-worth of 529 contributions with the current gift tax limits, so in 2022, that would be $80,000.
In addition to flexible funding opportunities, there aren’t annual limits on tax-free withdrawals for qualified education expenses. Remember, there is an annual $10,000 limit when you use 529 funds for K-12 expenses.
Minimal Impact on Financial Aid
The assets you keep in a 529 plan receive favorable treatment on the FAFSA (Free Application for Federal Student Aid).
FAFSA considers 529 account funds as a parental asset and can only decrease your child’s eligibility by a maximum of 5.64% of the account’s value.
As a result, 529 accounts are one of the best ways to fund your child’s education while limiting the effect on their financial aid package.
A word of caution: If a grandparent or other non-guardian owns the 529 accounts, there may be a more significant impact on aid eligibility. In these instances, you don’t have to report assets, but FAFSA views distributions for college as cash support to the student.
This technicality may reduce the child’s financial aid eligibility by as much as 50% of the distribution amount.
Anyone Can Be A Beneficiary
There are no age, income, or other restrictions to being a beneficiary of a 529 plan. The beneficiary can even be the same person who sets up the account.
529 Plans also make it easy to change beneficiaries if needed. So if your child doesn’t use all the money in their 529, you can update the beneficiary to another child or family member.
Potential Drawbacks of 529s
While it’s easy to see why 529 plans are one of the most popular ways to pay for higher ed, they’re not without limitations. Understanding potential cons will help you decide if a 529 Plan is the best investment option for your future student.
Tax Penalties For Unqualified Withdrawals
You can withdraw money from your 529 plan anytime, for any reason. However, if you don’t use the money to pay for qualified education expenses, you’ll likely need to pay a penalty along with income tax on the distribution.
Nonqualified withdrawals may incur a 10% penalty and be subject to income taxes. Both the penalty and the taxes apply only to the earnings in the account. You’ll owe the income tax at the Federal and state levels, while the penalty will be a separate charge.
Limited Investment Options
Unlike an IRA, you can’t invest the funds within a 529 plan anywhere you want. There are limitations when it comes to investing, and typically you have to choose investments within the plan’s offerings.
You can select among investment portfolio options, which usually include mutual funds and exchange-traded funds (ETF). Keep in mind that some plans have more comprehensive investment options than others, making it beneficial to shop around for one with low fees and a selection that complements your risk tolerance, time horizon, and goals.
How to Open a 529 Plan
Does a 529 plan sound like the right option for you? Great! Here’s how you can start opening one.
Step 1: First, choose a 529 Plan from the state that works best for you.
Step 2: Then, designate a beneficiary.
Step 3: After completing the application, add funds to the plan and choose your investments.
And that’s it! Creating a 529 Plan is an easy way to put your child on the path to educational (and financial) success.
If you’re unsure which plan to choose or need help setting up your plan, don’t hesitate to schedule a call with us. Chladek Wealth can help you compare plans and find the best fit for your family’s situation.
Reach out today to get started.
The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article.
All investment and financial planning strategies involve risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.