Oct 15, 2020
A 529 savings plan can be quite ambiguous with its changing rules and state-specific details. Understanding how this plan works and the advantages can be beneficial for your financial future.
According to the College Savings Plans Network, Americans currently have $371.5 billion saved in over 14 million 529 plans. However, a survey released by CSPN also found that while 35% of Americans are aware of 529 plans, only 26% knew it was connected to education.
With the average college tuition increasing at a steady rate of 3% annually, understanding how a 529 plan works is an important step for financially-savvy parents saving for their children’s education.
What’s a 529 plan?
Simply stated, a 529 savings plan is a tax advantage plan that encourages savings for future educational costs. Savings in this plan must be used for qualified educational expenses, such as books, tuition, and other school fees. Traditionally, this type of account could only be used for college expenses, but now it can be used to pay for K-12 education, certain types of apprenticeships, and even student loan repayment.
How does a 529 plan work?
This type of specialized savings account is used to save money for college. Each 529 plan has an account owner, who controls the investments and selects the beneficiary. The account owner and beneficiary may be the same person.
After the funds are contributed, the money is invested in age-based funds that align with the time period for when the beneficiary will be in college. Any earnings are tax-free, meaning no Federal taxes are applied to any earnings on qualified withdrawals.
The beneficiary is covered at just about any type of college or university in any state since funds can be used at eligible schools nationwide.
It's important to note that withdrawal from this type of plan can be taken at any time and for any reason, but if the money is not used for qualified education expenses, then federal income taxes may be due on any earnings withdrawn. A 10% penalty and a possible state or local tax can also be added. There are exemptions to the 10% penalty, like if your child receives a scholarship or attends a US Military Academy, but the earnings would still be subject to federal income tax as well as any state and local taxes.
What are the benefits of a 529 plan?
While the obvious cost savings for tuition is the primary reason parents start a 529 plan, the tax incentives for the contributor can’t be overlooked. As an individual, you can contribute up to 15K towards this endeavor, and 30k if married — which can dramatically reduce your tax liability. You can also contribute 75k and 150k, respectively, for the single and married taxpayer in a single year without eating at your lifetime gift-tax exemption.
When should you start a 529 plan?
With many new parents turning baby shower gifts into college savings, it’s safe to say it’s never too early to start saving for your children’s education.
Let's say that you want to have $25,000 saved for your child to use for college expenses once they turn 18. For this example, let's expect an average annualized return of 7% on your investments.
If you start saving when your child is born, you can easily set aside $56/month, or $669 annually, to meet your goal. As time passes, the more you'll have to save on a monthly basis to reach that goal. So if you start saving when your child is 10 years old, you'll now have to save $175/month, or $2,100 annually, to meet the same goal.
While there's never a perfect time to start saving for college, the key is to avoid procrastinating and open a 529 plan as early as possible. Plus, most 529 plans have very small or no initial contribution requirements and don’t require monthly contributions.
Who can contribute to a 529 plan?
Anyone, with any income, at any time, can open a 529 account. If you’re a U.S. citizen/resident alien and at least 18 years old, there are no income requirements or contribution limits. And the neat part about this type of savings plan is that you don't have to go at it alone. Relatives of the beneficiaries can contribute and participate in the tax benefits per the IRS regulations.
From calculators to infographics, there are many online tools available to help you determine how much to save in your 529 plan, but having the expert help of a financial planner can also help you understand how this type of savings plan fits into your overall financial plan.
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