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Your Guide to 529s

Although kids are on summer break, planning for college expenses can be a year-round job. With college costs increasing at a staggering rate, our clients often contemplate how and whether to support their kids' and grandkids’ education funding. Additionally, new federal tax reform laws have expanded the use of 529s for K-12 tuition, apprenticeship programs, and student loan debt, opening the opportunity to fund a child's entire education, not just college.

Section 529 of the Internal Revenue Code was created in 1996 to provide a way for families to save for the rising costs of higher education. By 2000, 30 states had launched a 529 plan. Today, 49 states, plus the District of Columbia, offer a 529 plan.

States often have two kinds of 529 Plans: the Prepaid Tuition Plan and the College Savings Plan. 

The Prepaid Tuition plans cover all tuition and fees at public colleges or universities within the state. Room and board are not covered by the pre-paid plans. States offer flexibility regarding how many years to buy – just one or two – or all four. If you are certain that the student will go to an in-state school, the Prepaid Tuition plan can be a great way to plan for college. However, if the student ends up going to school out of state or to a private school, the plan will provide the invested principal plus a small amount of earnings to use towards the out-of-state school, which may or may not cover the full cost of attendance. Prepaid tuition plans have dwindled in past years due to the difficulty in gauging higher education costs. Only 9 states still offer them to new enrollees. If you contributed to a prepaid plan that has since closed, however, your contract is still valid.

The second type of 529 is the College Savings Plan. Money contributed to this type of 529 grows tax-free and is distributed tax free if it is used for qualified higher educational expenses (QHEE). College Savings offer a variety of mutual funds or target-date funds, which become more conservative as the student approaches college attendance. Check out a full list of qualified higher education expenses here.

Unlike a custodial account, a 529 plan is not owned by the child but is instead owned by the parent or grandparent, etc. The student is the beneficiary of the account.  It’s important to note that only funds used for qualified higher education expenses are distributed tax-free. Funds distributed for any other reason will incur taxes on the earnings AND a 10% penalty – similar to a premature IRA distribution. Recent legislation also changed how grandparent-owned 529s are counted in financial aid decisions. Certain types of untaxed income, such as cash support and money paid on the student’s behalf, will no longer be reported on the FAFSA. Now grandparents can open and maintain a 529 without worrying about FAFSA eligibility.

If you don’t end up using all the money in the 529 account, you can change the beneficiary to a sibling, cousin, or a whole host of familial relations. If your student is fortunate enough to receive a scholarship you can withdraw an amount equal to the scholarship from the 529 plan without penalty. There would be, however, taxes owed on the gains.

Additionally, many states offer a state income tax deduction for contributing to your state’s plan. Some states, including Pennsylvania, Arizona, Minnesota, and Missouri, offer a deduction for contributing to any other state’s plan. States also differ in whether they offer a direct-sold (sold by the state) or advisor-sold (sold through licensed financial advisors).

Contributions to a 529 plan are considered gifts for tax purposes, and gifts can be made with excess required minimum distributions from retirement accounts or from other sources. For 2022, contributions of up to $16,000 per individual—$32,000 per married couple filing jointly—qualify for the annual gift tax exclusion. What’s more, you can gift as much as $80,000 individually and $160,000 jointly to a 529 plan at one time if the contribution is treated as if it were spread over a five-year period.

As with other investments, the earlier you start saving for college education, the more time you will have to grow your savings. If you didn’t start saving when the child was born, there are still options to fund college. As you map out a plan for your student’s education, be sure to check in with your team at The Wise Investor Group. We can help you weigh the pros and cons of the various options and help you design a strategy to fit your education goals. 

Helpful Links:

529 Frequently Asked Questions

Grandparent Rule

Want to hear more about 529s? Listen to our latest episode where Host, Simon Hamilton and Guest, Ann Summerson, discuss the ins and outs of 529 College Savings Plans.

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