While there are many different options available to help save for a college education, 529 plans continue to be one of the most popular savings vehicles.
Here's how they work: They are funded with aftertax dollars, which then grow tax-free. Withdrawals for qualified education expenses are also tax-free. On top of that, some states offer tax deductions or credits for contributions.
Setting up and contributing to a 529 college-savings plan is usually a fairly straightforward process. But whether you are new to 529s or already invest in a 529 account, understanding more about the ins and outs of how these plans work can help you maximize your investment.
IRS Publication 970 contains some helpful information, such as details about "qualified" educational expenses. It's a dense read, but you can skip to section 8 on qualified tuition plans.
Here is some must-know information regarding the mechanics of 529s and how the plans work.
1. You can change the beneficiary.
The IRS rules state that provided the new beneficiary is a member of the original beneficiary's family--for example, a sibling or even a parent--the new beneficiary can use the funds in the 529 account for educational purposes without a tax penalty.
There are a few reasons why this is a desirable feature. For one, if one of your children doesn't use all of the funds you've saved--say he or she decides not to go to college or wins a scholarship--you can apply those unused funds toward a younger sibling's college education, or you could use the funds to pursue your own higher-education goals.
2. 529 assets have a lower impact on need-based financial aid than some other college investments.
Similar to a Coverdell ESA, the money in a 529 account has a much lower impact on need-based financial aid than student-owned assets do.
Information reported on the Free Application for Federal Student Aid is used to calculate the expected family contribution using a formula established by law. There is a maximum of 5.64% of parental assets counted; meanwhile, assets that are held in the student's name are counted at 20%. This difference is significant because a higher expected family contribution means less financial aid.
3. You don't have to stay in-state.
You may want to invest in your state's 529 plan, depending on how good your state's plan is in terms of costs and investment options and what types of incentives your state plan offers you. For instance, some states allow you to receive a deduction or credit for 529 contributions on your state income tax.
But if other states offer better plans, your state's tax break is weak, or your state provides a tax break on investing in any state's 529 plan, it may pay to shop around. For example, if another state's plan offers superior investment options and/or lower costs, it may even offset the tax benefits you'd receive by staying in-state. For more, see this article. You can see Morningstar analysts' 2018 ratings of 529 plans here.
4. You can invest $75,000 (or $150,000 jointly with your spouse) in a lump sum.
If you make a contribution of up to $75,000 (or up to $150,000 for a married couple) to a beneficiary's plan, you can elect to treat the contribution as having been made over a five-calendar-year period for gift-tax purposes. (This is sometimes referred to as superfunding.)
There are a few reasons you might want to do this. For one, making a lump-sum investment allows your money to compound on a tax-free basis for a longer period of time. This could be beneficial especially for those who have long time horizons before the college matriculation date approaches, as many plans with longer time horizons have a stock-heavy allocation in the earlier years. Having more time in the stock market gives you a better chance of outpacing the rate of tuition inflation.
In addition, superfunding means the money gets out of your estate faster than if you made contributions each year, which could be beneficial from an estate-tax perspective.
There are some caveats to superfunding, however. For one, gifts above $15,000 a year typically require that you spread the amount equally over five calendar years and complete IRS form 709 with your federal tax return in each of those five years. Also, any amount in excess of $15,000 per year on this prorated basis must be counted toward the individual's lifetime gift-tax exclusion limits (the federal lifetime limit is $11 million per individual).
5. Know the rules when using 529 funds for nonqualified expenses.
Although it's not advisable to pull money out of a 529 because you can face serious tax consequences and penalties for doing so--not to mention you would be derailing your college savings plan--sometimes in an emergency situation or after a job loss, you are left with few better alternatives.
In such cases, it may be better to tap college savings vehicles before retirement-savings vehicles, considering that there are other ways, such as student loans, to pay for college but there are fewer options available to fund one's retirement. In addition, it's easier to get money back into a 529 than it is to get it back into an IRA or 401(k) once you've pulled it out, because you're subject to annual limits on retirement contributions--the 529 contribution limits are much less onerous, especially given that the gift tax isn't a concern for most households.
You can tap the portion of your 529 balance that comes from contributions without tax penalty because the contributions were made with aftertax dollars. However, you will be subject to a 10% penalty on the earnings portion of your balance, as well as any applicable federal and state income taxes. (The 10% penalty is waived, however, if the beneficiary dies or becomes disabled, or if he or she receives a scholarship.)
One thing to note, however, is that plans make distributions on a pro-rata basis, which means that you can't simply withdraw your contributions and leave the earnings in the account as a way to avoid paying taxes and a penalty.
The other wrinkle here is the tax break on state taxes. If you've claimed state income tax deductions for contributions to a 529 plan, you might owe back taxes on any tax breaks you received if you use the funds for nonqualified expenses.
6. You can invest in more than one type of education savings vehicle.
For the most part, college savings vehicles are not mutually exclusive; in some cases, savers may benefit from holding one or more account type. For instance, assume a family wants to set up a Coverdell Education Savings Account to save for elementary and high school expenses and a 529 to save for college expenses.
Even though 529s can now also be used for elementary and secondary school, they allow $10,000 in tax-free withdrawals for tuition only. The definition of qualified educational expenses is more liberal with a Coverdell: Along with tuition, qualified expenses can include books, supplies, equipment, tutoring, and services for kids with special needs.
However, the Coverdell's lower yearly contribution amounts ($2,000 per beneficiary, per year) will not be sufficient to fund elementary and high school costs, as well as future college costs. For this family, it may make sense to direct their contributions toward both a 529 plan and a Coverdell.
Here's an alternative scenario: Because there are no restrictions on who can set up a Coverdell account and the contributions do not have to come from earned income, a grandparent could open a Coverdell account for the beneficiary in the example above. This could be a good option for a family whose income levels exceed the maximum allowed for a Coverdell account (less than $110,000 for a single filer or $220,000 if filing a joint return). There are no income restrictions for 529 contributors.