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What is a 529 Plan?
A 529 plan is a savings plan that helps students and parents save for educational expenses. The big benefit of the 529 plan is that there are tax benefits for contributions, and withdrawals are not subject to federal income tax or (usually) state income taxes.
So, your 529 plan grows with these benefits and the earned interest is tax-free! The longer that your money is in a 529 plan, the more opportunity it has to grow. This means that you will have more money to pay for education! 529 plans are sponsored by individual states, state agencies, and educational institutions.
Related: How much to save for college
What can a 529 plan be used for?
529 plans pay for “qualified educational expenses,” including tuition, room, board, mandatory fees, and even computers or software (if required). Qualified expenses occur in the context of college, elementary, or secondary schools. Vocational and trade schools are also included, as well as costs related to homeschooling. Additionally, thanks to the SECURE Act, 529 plans now pay for student loans.
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Are there different types of 529 plans?
There are two types of 529 plans:
- Prepaid Tuition Plans
- Educational Savings Plans
Let’s get into the differences between these two types:
Prepaid Tuition Plans vs. Educational Savings Plans
The first type of 529 plan, the Prepaid Tuition Plan, allows students and families to purchase “units or credits” at specific colleges. This means that you are locking in tuition and other fees at their current rate. This matters because even if tuition climbs up (which it generally does), you will only pay the current price. Most of the time, this Prepaid Tuition Plan is for public, in-state colleges and universities. Therefore, it is only available to residents of a particular state. Note that this option does not allow you to pay for room and board, or pay for elementary or secondary school tuition. The biggest risk of this option is if you don’t wind up attending one of the participating institutions. This can result in a situation where your Prepaid Tuition Plan does not cover the cost of attendance.
An Educational Savings Plan is a more traditional investment account for tuition, mandatory fees, and room and board. To save with the Educational Savings Plan, an individual can choose from a number of investment options from banks and other investment companies. The risk/reward of the Educational Savings Plan is that you invest in assets such as mutual funds or exchange-traded funds that can go up or down.
Also read: Which 529 plan assets are reported on the FAFSA?
Do all states offer a 529 plan option?
According to the U.S. Securities and Exchange Commission: “all fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a prepaid tuition plan.” This means that regardless of where you live, you can take advantage of this savings option!
Related: How to choose the best 529 Plan for you
Can a 529 plan impact need-based financial aid?
Yes, a 529 plan can impact need-based financial aid for students. However, this will vary from college to college. It can also vary based on the amount of money in the account and the owner of the account. For more information on how to maximize your 529 savings without reducing your financial aid, check out our article.
See also: How much is the 529 plan deduction worth?
529 plan tax benefits
You might be wondering what the exact tax benefits are which the 529 plan offers. There are two levels of tax breaks – federal, and in some cases, state breaks.
For federal tax breaks, your capital gains and withdrawals will not be taxed. That means that you won’t pay any federal tax on the interest that grows in the account, as long as you spend it on approved educational expenses. You’ll still pay taxes on the initial income that you place into the account, but the growth, which would usually face substantial taxes, goes untaxed.
State tax breaks vary on a case-by-case basis. Some states offer a tax deduction for 529 plan contributions. That means you’ll be able to deduct your contributions from your taxes, potentially earning a refund or a reduced balance at the end of the year.
Related: 529 plan rules
What happens if my child doesn’t attend college?
If the account beneficiary doesn’t end up attending an approved educational institution, you can change the beneficiary to another family member without incurring any penalty. You also have the option to withdraw your funds and use them for whatever you’d like. But keep in mind, if you do this, you’ll have to pay taxes on all of the capital gains, and pay a 10% charge on top of that.
When should I start a 529 plan?
It’s never too early to start a 529 plan! If you’ve got even a small bit of income to put aside monthly, consider starting a 529 plan for your child. Remember, the longer the money stays in the account, the more it grows. So, if you start saving early, you’ll thank yourself later. If plans change and your child doesn’t end up attending college, you can transfer the account to another name, or withdraw it for other expenses, with a penalty.
