If you have already started a family, you may want to know, "What is a 529 Plan?" Here is everything you need to know.
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Guys and gals – this post is for those of us who have started families or are considering starting families.
Why? Because we’re talking about 529 Plans – better known as College Saving Accounts!
Normally I don’t write blog posts about financial terms or financial concepts that have to do with kids – but I figured that today I’m going to write about something different: Something having to do with kids. Gasp!
What started me on this subject?
Quite frankly, I was talking to one of my best friends (actually, I’m going to be her maid of honor at her upcoming wedding).
She just turned 30 and will be marrying the love of her life.
Sadly, we don’t get the chance to talk all too often because she lives on the other side of the country with her fiancé, soon to be husband.
So once in a while, we pick up the phone and talk for hours on end to catch up.
I’m sure if you have a close, long-distance friend you may have had a similar experience… when you talk, you talk for a very, very long time.
Anyway, during one of our hour-long conversations, the “k” word came up.
I asked her if she already had considered having kids in the future with her man.
She smiled (we were on FaceTime) and started nodding her head.
Now, this is the type of girl who carefully follows a budget and is pretty well versed when it comes to financial literacy.
However, her next question threw me out of the loop, which is why I decided to blog about the topic: 529 plans.
As we started digging into potential names for her future son and daughter.
(Hopefully her soon to be husband is not reading this blog post, because he’ll likely want some input as well), the topic about college savings popped into the conversation.
First, my bestie asked me what my recommendation would be to efficiently start saving for college at an early age.
So, I replied by saying a 529 account would most likely be the best option for her to start for the likely exorbitant amount of money that it would cost for her future kids to attend college.
Then again, isn’t the cost of college already at ridiculous levels?
Second, as I mentioned the 529 plan, my bestie asked me to explain what a 529 Plan is and how it could be best utilized to gain a large return on investment.
That made me think that if my best friend – who is more financially literate than the majority of friends in my circle – didn’t know the ins and outs of 529 Plans, then there is a likelihood that others may also not know what 529 Plans are and how they can be used most efficiently.
And that conversation with my best friend is what led me to write this blog post today!
How does a 529 plan work?
Well, my dear friends, for those of you who were lucky enough to have all or a portion of college paid for you by your parents or your guardians – then chances are that money very likely came from a 529 Plan.
Of course, there are other accounts and savings vehicles that could have been used to pay toward your college education – and we can dive into the details in another post, but as I said, chances are that your parents likely used a 529 Plan.
Let’s start by defining the basic terminology:
What is a 529 Plan?
A 529 Plan is a fancy word for a college savings account. Specifically, a tax-advantaged college savings account.
What that means is that anything you put into your 529 Plan will grow tax-deferred.
(In other words, you won’t have to pay taxes on the growth of the earnings on your initial 529 Plan contributions).
AND anything that you decide to withdraw from a 529 Plan that is used toward QUALIFIED expenses (in other words, expenses used specifically for college) will be tax-free!
Again, pay close attention to the word qualified expenses.
Typical Qualified 529 Plan Expenses:
- Student Loans
- Tuition & fees
- Room & board
- Supplies & equipment
In general, the definitions of “supplies and equipment” for example is often very liberal.
In other words, you could bend the rules and still get away with a “qualified” expense where you won’t have to pay a 10% penalty and income taxes on any of the earnings of the 529 Plan withdrawals.
Room and board for example could mean that a 529 Plan withdrawal may be qualified even if the room and board are NOT technically on campus.
There may be certain limits though as it relates to how much of that withdrawal is considered qualified toward off-campus housing.
Again, it depends on the plan, the type of college, and the state you are in.
Consult with an attorney, accountant, or your financial advisor in order to make the best and most correct decision for you and your child.
Depending on the type of 529 Plan you enroll in, the term “qualified” could mean different things.
As an example, one 529 Plan could consider monthly wi-fi expenses to fall under qualified expenses, because technically a student would need wi-fi access to submit or work on certain assignments away from the classroom.
Other plans, however, may not accept monthly wi-fi payments to fall under qualified expenses.
This is where you need to read the fine print of your plan – or contact your financial advisor to better understand your specific 529 Plan’s technical jargon.
The money that you can withdraw from 529 Plans can be used for K-12 (where withdrawals are limited to $10,000 per year) or for college (where withdrawals are not limited).
Note: There are 2 different types of 529 Plans.
One is called a Savings Plan and the other is called a prepaid tuition plan.
For the purposes of this blog, we’ll be examining 529 Savings Plans.
What 529 plan should I choose?
Guess how many different 529 Plans there are. Anyone? Anyone? Bueller?
There are 51 different 529 Plans.
Why? Because 529 Plans are state-run (plus Washington D.C.).
This means that each state administers its own 529 plan, so since there are 50 states plus the District of Columbia in the United States of America, there are 51 different 529 Plans.
What’s the difference between 529 Plans?
It’s simple – there are only slight differences.
However, similar to a 401k plan, each state typically sets forth which type of investment you are permitted to invest in – you don’t have a free choice when it comes to 529 Plan investing.
Some 529 Plans are more expensive than other plans. By expensive I mean the fund fee ratios within the plan itself.
As you may know – there is no such thing as a free lunch, and if you invest your money in a specific fund, there will always be fees associated with that fund (to pay the fund managers who decide how the fund is invested).
Sometimes those fund fees can be pretty expensive – or ranging from 1% or more.
Other times those fund fees could be fairly inexpensive, where we see the expense ratio dropping below 0.1% (that’s a tenth of a percent).
Can I invest in any 529 plan?
The short answer: Yes you can.
There is the common misconception that you only can invest in the 529 Plan from your state – but that’s incorrect.
In fact, if you live in Vermont, you could technically invest in the 529 Plan administered by the state of Hawaii!
That of course doesn’t mean investing in a Hawaii 529 Plan is the best option for you, but it’s doable.
Some plans I have seen successfully used include the New York 529 Plan and the Nebraska (go figure) 529 Plan.
The fund options within the plan are fairly broad and inexpensive, which are two attractive features when considering establishing a 529 Plan for your child.
Here’s another small tax trick that might help you along the way.
For those of you living in states where you do see state taxes AND federal taxes (such as Illinois or Massachusetts for instance), you could select your own state’s 529 Plan to invest money for your child’s future education.
When you invest money in your state’s respective 529 Plan, you could be eligible for a state tax deduction for the contributions you make into that state’s 529 Plan.
However, if you move to another state then the likelihood is that you may no longer be eligible for state income tax breaks.
The best solution, in this case, could be to open a new 529 Plan and make your contributions to your new state’s plan.
(Assuming your new state also has a state income tax) or to consult your CPA.
Unfortunately for the purposes of this blog, it’s difficult to get into personal situations as it relates to 529 planning because 529 Plans are administered on a state-level and there are so many different 529 Plans with different rules and stipulations.
However, now that you know there are some ways to save money on taxes when you invest in certain 529 Plans, you at least know which questions to ask your accountant for further clarification on your tax situation.
Who can open a 529 Plan?
The broad answer is that anyone can open a 529 Plan.
However, it is very typical of parents or grandparents to open 529 Plans for their children or grandchildren.
However, you MUST have a social security number to begin investing in a 529 Plan.
This means that you cannot start saving for your unborn child.
You must have a child with a valid social security number to open a 529 Plan account.
The person opening the 529 Plan selects how to invest the contributions.
The typical rule of thumb is if your child is a newborn baby, you’d likely want to invest in a more aggressive portfolio since you generally will have 18 years until that child will need the funds for college.
As the child nears college age, you’d typically want to reduce your aggressive exposure so that in the case of an economic downturn, your 529 Plan’s overall investment portfolio will not be adversely impacted.
Have no fear: If you are not a savvy investor (and let’s be honest, most of us are not), and if you are not sure how to invest and which funds to invest in, that’s OK.
There are other investment options known as target-date funds within the 529 Plan.
These are funds that essentially automatically adjust the aggressive exposure (or lack thereof) within the account as the child nears its college years.
As an example: as the child becomes older, the target date fund automatically adjusts its portfolio allocation to become more conservative (not as aggressive) without you having to think twice.
Target date funds are not customized to the child’s (or your) risk preference (as some people are inherently more risk-averse than others) and target-date funds typically are more expensive than other fund options.
Pro Tip: Next time you celebrate a birthday or holiday for your child, instead of having your friends and family give your child gifts, I would suggest to ask them to write a check for any amount out to your child’s 529 Plan!
This is money that your child will truly need and thank you later if they decide to go to college.
Does a 529 Plan Affect Financial Aid?
Yes, anyone can open a 529 Plan. But – is there someone who may be ideal to open a 529 Plan for a beneficiary?
The answer here really is it depends on the situation, but I can certainly provide you with a situation where having one 529 Plan owner over another may be more beneficial for the prospective college student.
Assuming that college students will be applying for financial aid as well.
If a 529 Plan is “owned” by a parent and that child is filing a FAFSA financial aid form, then the 529 Plan assets could be counted toward the parent’s investment assets, which could ultimately decrease the child’s overall financial aid eligibility.
Of course, there is also the question of the parent’s income, and if the income is lower than average, the 529 Plan assets really won’t count against the child’s eligibility.
If a 529 Plan is “owned” by a grandparent for example (this is a scenario I commonly see), then the 529 Plan assets will NOT be counted against the child’s eligibility for financial aid.
In other words, the total amount within the 529 Plan would not be considered an investment asset on the FAFSA application.
Any withdrawals from 529 Plans NOT owned by a student’s parents would then be considered non-taxable income to the student and up to 50% of the withdrawal amount could negatively influence the student’s financial aid eligibility.
There is, however, a workaround to this situation.
Assume your grandparents own your 529 Plan.
Because FAFSA has a two-year lookback period when determining financial aid, you could take the 529 Plan withdrawals starting at the beginning of your junior year in college.
(Assuming you are in college for 4 years).
By starting the 529 Plan withdrawals in your third year of college, the lookback period will likely not “see” the withdrawals taken from the 529 Plan, so your financial aid eligibility generally won’t be negatively impacted.
Moreover, with the passing of a recent law, you could also use any of the 529 Plan withdrawals to pay off your student loans from the first 2 years in college if you decided to wait and avoid taking withdrawals from the grandparent owned 529 Plan.
Paying off student loans, under the new law, is considered a qualified expense.
What if I don’t use the 529 plan money for college?
Let’s say you start saving for your child’s 529 Plan, believing they will attend college at age 18.
And lo and behold, your child became an international pop sensation.
No college. Just world traveling and making money through their hit songs.
How do you get that money out of the 529 Plan that you so diligently saved for?
There are two general options. First, you simply withdraw the money.
The only downside is that you’ll likely see a 10% tax penalty on top of paying income taxes on the earnings of your 529 Plan contributions.
Another consideration here is that if you did receive a tax credit (in other words you did not have to pay all or some) of your state income taxes because you contributed to your respective state’s 529 Plan…
There may be a chance that you would have to pay back the tax credits you received in earlier years.
This is a conversation to be had with your CPA, however.
A second option is that you transfer the 529 Plan to another beneficiary.
This can be done tax-free and once per year.
You do not have to change your state plan, you simply can request beneficiary change paperwork and transfer to someone else.
Here’s the catch if you decide to transfer your 529 Plan: the new beneficiary MUST be another family member.
- Child, adopted child, foster child, or descendant of a child
- Brother, sister, stepbrother, stepsister
- Father or mother or ancestor of either
- Son-in-law, daughter-in-law
- Spouses of any of these individuals
- First cousins
There’s more, but you get the point.
What can I do with unused 529 funds?
As mentioned above, if your child receives a scholarship and there still is money leftover in your 529 Plan, then you could change the beneficiary to someone within your family.
Or, another option could be to keep the money in the 529 Plan with the assumption that your child may want to pursue a graduate degree, in which case your 529 Plan money would still be eligible.
Third, you could simply withdraw the money, expecting that 10% penalty and income taxes on the earnings.
There are two types of 529 Plans:
Savings Plans and Prepaid Tuition Plans. This blog article particularly focuses on the Savings Plan.
You have 51 different options to choose from and start investing in your child’s future college career.
There are some tax advantages if you decide to pursue the 529 Savings Plan and your child will certainly thank you later if you are lucky enough to set aside some extra money for your child’s college tuition.
The most important item to consider here is whether it’s $25 per month or $1,000 per month that you can set aside and save for your child’s college tuition, start early.
You have (presumably) 18 years until that money will be used.
To amass more money in your 529 Plan, consider asking friends and family for checks in any amount to be written out to your child’s 529 Plan as opposed to purchasing toys during holidays or birthdays.
This is a trick I have a few of my friends implement and they are LOVING it.
Their children will be wealthier than their parents! (Just kidding).
Stay smart, invest wisely, and stay committed. Your bank accounts will thank me later!
Have you considered starting a 529 savings plan? If so, what is your investment strategy?