Saving for college can be daunting, but a valuable tool may be flying under your radar: the 529 Plan. Surprisingly, an estimated 64% of Americans don’t even know what these tax-advantaged accounts are about. [i] With recent tax law changes, 529 Plans are now more flexible than ever, offering benefits not just for education but also for long-term financial planning. This article will explore why this plan could be the key to balancing education savings with broader financial goals.
What’s a 529 Plan?
A 529 plan is a tax-advantaged investment account designed to make saving for education easier. It offers significant tax benefits, including the tax-deferred growth of investments and tax-free withdrawals for qualified education expenses. Here’s an overview of how it works.
- Find a plan. All U.S. states offer at least one 529 plan. Surprisingly, you’re not limited to choosing one based on your residence or even where your child may attend college. However, many states offer incentives for their residents to use those plans, including state tax benefits on their plans.
- Start making contributions. Once you establish the account, you can begin making contributions. Anyone may contribute to a child’s account, so grandparents and others may chip in if they’d like. While there are no federal contribution limits, some states impose their own limits, which are usually relatively high. The IRS considers contributions gifts, so be aware of gift tax limitations. You don’t usually need to report the gift as long as you stay below the gift tax limit for that year.
- Invest the account balance. Like an IRA, the money can be invested, often in mutual funds, ETFs or similar products. Then, the money in the account grows tax-deferred, meaning you won’t pay taxes on any earnings as long as they stay in the account.
- Withdraw money for qualified expenses. When it’s time to pay for education costs, you can withdraw the money free from federal taxes, provided the expenses are qualified under the 529 rules. Many states also allow tax-free withdrawals, but there are a few cases where certain states may impose taxes on these withdrawals. Be sure to check your state’s specific rules.
Recent Tax Law Changes Put an End to Stranded Money
In the past, 529 Plan users often ended up with unused balances stuck in the account. However, with recent tax law changes, unused balances can now be rolled into a Roth IRA for the beneficiary. [ii] This is a game changer that adds significant flexibility for unused funds.
Do 529 Plans Limit Choice of Schools or Location?
No. One common misconception is that you can only use a 529 for in-state public colleges. That’s a myth. A 529 Plan can be used for most accredited colleges and universities in the U.S., both public and private, and even some international institutions.
And, these plans offer even more flexibility. For example, you can even use the funds for vocational and trade schools, K-12 tuition, or qualified apprenticeship programs.
Benefits Beyond Just Saving for College
In addition to tuition, the 529 Plan can pay for other related expenses recognized as qualified education expenses. [iii] These can include room and board, computers, and even the cost of books.
Then, the new tax law also authorized that up to $10,000 of unused funds can also be used to pay outstanding student loans.
What Happens if Your Child Doesn’t Go to College?
One huge benefit of 529 plans is the flexibility they now offer. If your child decides not to attend college or opts for a less expensive option, like a certificate program, you aren’t locked into a narrow set of options or faced with unusable balances. You can put it into a Roth IRA, or you can change the plan’s beneficiary to another family member, such as a sibling, without incurring taxes or penalties. You can even use the balance yourself if you decide to pursue additional education.
When it comes to the Roth IRA rollover, there are some limitations. These recent tax law changes allow up to $35,000 of unused funds to be rolled into a Roth IRA tax-free, provided certain conditions are met.
Please note that the Roth IRA rollover provisions are new and still getting ironed out in many states. Plus, the account must be in place for at least 15 years to use that provision. Still, this can be a fantastic benefit to provide a retirement head start for your child.
Beyond Saving for College: Estate Planning Opportunities
With this added flexibility, a 529 plan can also serve as a legacy planning tool. If your child doesn’t need all the funds, the account can remain open for future generations, providing an ongoing educational resource. Plus, you can change beneficiaries within your family, ensuring the funds can benefit other relatives. And, if funds remain, the Roth IRA rollover remains an option.
Understanding the Potential Drawbacks of a 529 Plan
While 529 plans are more attractive than ever, they still have some potential drawbacks, primarily in requiring careful management. Some potential pitfalls include:
- Record Keeping: You are responsible for tracking qualified expenses, so be diligent about maintaining receipts.
- Contribution Limits: Annual contributions count toward federal gift tax limits, so be careful of those. You can explore other options with your tax professional, such as front-loading the account for five years to gain additional benefits. Regardless, be sure to be cognizant of requirements and limits.
- Go Slow with Roth Conversions. This provision is new, and the law is still unclear, so some clarification is expected. If you proceed sooner rather than later, work with your tax professional on this process.
Key Takeaway: Is a 529 Plan Right for Your Family?
With recent tax law changes, the 529 Plan has evolved into a multi-purpose financial tool that could play a role in education, retirement and estate planning. If you’re looking for a way to save for future college costs, you might want to give the 529 Plan a second look.
Please be aware that this article is intended for general education. Please see your tax professional for specific recommendations.
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[i] https://www.investmentnews.com/industry-news/many-americans-dont-know-what-a-529-plan-is/206798
[ii] https://www.savingforcollege.com/article/roll-over-529-plan-funds-to-a-roth-ira
[iii] https://www.irs.gov/credits-deductions/individuals/qualified-ed-expenses
