College expenses can be daunting for parents looking to pick up the tab. However, utilizing a 529 education savings plan can help. A 529 plan is a tax-sheltered account that allows you to save for higher education expenses for yourself or a beneficiary such as a child, grandchild, relative, and even a friend. The catchy name comes from the section of the Internal Revenue Service code that established the program—section 529.
Let’s review four key advantages of using a 529 savings plan and a few constraints to keep in mind.
Four Advantages of a 529 Savings Plan
- Tax free growth – A 529 can be opened by anyone willing to contribute to your child’s college education. Once the account is open, the account owner selects investments from a menu of investment choices. The investment choices range from conservative (100% bonds) to aggressive (100% stocks) and any combination in-between. Contributions to the account are then invested into the selected asset mix. Over time and with additional contributions, the investments within the account compound gains and interest until the funds are needed. When it’s time to withdraw funds for college, the account owner sells the investments in the account. Any earnings on the investments are not taxed, as long as the proceeds are used for qualified education expenses such as tuition, room and board, books, fees, etc.In addition to tax free growth, some states offer state tax deductions for contributions to 529 plans.
- Flexibility – 529 plans offer flexibility to choose how the account is invested. You should consider how long you have to invest before the funds are needed for college. If the child is 10 or more years away from attending college, a more aggressive allocation may achieve more growth. If the child is closer to attending college, it may be prudent to invest more conservatively to limit volatility. 529 plans often offer age-based choices on the investment menu. Age-based investment programs automatically adjust the portfolio to become more conservative over time by reducing exposure to stocks and increasing exposure to bonds as the beneficiary nears college.
Additionally, account owners have the flexibility to use any state’s 529 savings plan. Do your homework and research various 529 plans that are available—some have better investment choices, lower fees or both.
Also keep in mind that a beneficiary of a 529 plan does not need to attend a school in the state that sponsors the plan. For example, an account owner can live in Michigan, invest in a 529 in Virginia and send their child to college in Florida.
- Portability – If the beneficiary doesn’t use all the funds, the account can be maintained and the account owner is allowed to change the beneficiary of the 529 account. If the account owner chooses to change the beneficiary there is one caveat—the new beneficiary must be a *qualifying member (see below) of the prior beneficiary’s family. If the current beneficiary has a sibling, it’s simple! You can change the beneficiary to the other sibling. If your child receives a scholarship and doesn’t need the funds for their undergraduate degree, the account can remain open and be used for graduate school expenses.
- Focus – 529 plans are specifically meant for college, much like a 401(k) is specifically intended for retirement. A designated account, with a clear purpose, simplifies saving for goals. 529 account owners can contribute periodically and dollar-cost-average into their selected investments over time. You should consider utilizing systematic savings features so you can automate savings from your paycheck or your bank account.
Constraints to Keep in Mind
Just like most tax advantaged accounts, 529 plans also have restrictions. If funds are withdrawn from a 529 as a non-qualified distribution (distribution for anything other than tuition and fees, books, supplies and equipment, academic tutoring, room and board, uniforms, and transportation) there is a 10% penalty on the earnings in addition to ordinary income tax on any earnings. If your child receives a scholarship, the 10% penalty on earnings is waived. However, ordinary income tax is still owed on the earnings.
Talk with your advisor about the options available and which plan would make the most sense for your situation.
*Qualifying members include: beneficiary’s spouse, beneficiary’s son or daughter or descendant of the beneficiary’s son or daughter, beneficiary’s stepson or stepdaughter, beneficiary’s brother, sister, stepbrother or stepsister, beneficiary’s father or mother, or ancestor of either parent, beneficiary’s stepfather or stepmother, beneficiary’s niece or nephew, beneficiary’s aunt or uncle, beneficiary’s aunt or uncle, spouse of any individual listed above, beneficiary’s first cousin, and any individual for whom the home of the designated beneficiary is his or her primary home for the entire tax year.