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529 College Savings Plan: What You Need to Know

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Posted by Choose FI

If you're looking for an efficient account to save for you or your child's college education, it's hard to beat a 529 college savings plan. These plans offer unique tax advantages and they're more flexible than other college savings tools.

But while a good portion of the general public understands how retirement accounts work, the average person may have little experience or familiarity with 529 college savings plans. How do you open a 529 plan? Which expenses can the funds be used for? And what happens if your child decides against attending college?

A 529 college savings plan is a post-tax account that students or their parents, family, and friends can use to save for college expenses. In order to understand if this is the best college savings plan for you or your child, you need to know how a 529 plan works, their pros and cons, and how they stand up when compared to alternative college savings accounts.

We're breaking it all down for you here so that you can decide if a 529 college savings plan is the right decision for your circumstances.

Table Of Contents

How Does A 529 College Savings Plan Work?

A 529 college savings plan is an account that allows you to save for college expenses in a tax-advantaged way.

529's are taxed like Roth IRAs. You can contribute to the plan with after-tax money (money you have paid income taxes on) but the money inside the 529 grows tax free and can be used without taxes or penalties as long as the money is spent on "qualified higher education expenses".

This means you do not get any tax advantages now, but you'll get a huge tax advantage later since all the growth in the account will be tax-free.

Also note, that while contributions to 529 savings plans are not tax-deductible on your federal tax return, some states do offer tax deductions and credits that could lower your state tax bill.

Related: The 4 Worst FI Tax Hacks (And What to Do Instead)

What Are Qualified Higher Education Expenses?

Now that we've explained the tax treatment of 529 college savings plans, let's define "qualified higher education expenses."

Tuition, room and board, textbooks, and supplies all count as qualifying education expenses. Additionally, up to $10,000 of 529 plans funds can be spent tax- and penalty-free towards tuition costs at K-12 schools.

Non-qualified expenses would include transportation costs, health insurance, or college application and testing fees. When 529 college savings plan funds are used towards non-qualified expenses, the withdrawal will be subject to a 10% penalty.

Listen: How To Get Paid To Go To College With Anthony Gary

Can You Use Any State's 529 College Savings Plan?

It's important to understand that there are two types of 529 plans: 529 prepaid tuition plans and 529 college savings plans.

With 529 prepaid tuition plans, you pay ahead for the tuition costs at an in-state public university. So if you want to contribute to a prepaid tuition plan, you'll need to use the one offered by your state. You cannot use this plan in any other state.

However, 529 college savings plan funds can be used at any college. You can also choose to use any state's plan.

If your state happens to offer a tax deduction or credit for using their plan, that's probably the best way to go. Otherwise, another state's plan could be a better option if it offers lower management fees.

See a list of the most affordable 529 college savings plans.

Do 529 College Savings Plans Hurt Financial Aid Eligibility?

The quick answer is, yes, 529 college savings plans can affect financial aid eligibility. But if students and parents are smart, they can limit the impact.

Financial aid eligibility is determined by two main factors: the student's available income and the student's assets. Income has a dramatically higher effect on student aid eligibility than assets. For example, parental assets only affect student aid by 5.64%, but student income reduces aid by 50%.

How Parent 529 Plans Affect Financial Aid Eligibility

Why does all this matter? Because the Department of Education views 529 plans differently depending on who is the primary account holder.

If the 529 college savings plans are owned by a parent or dependent student, the funds are considered parental assets on the FAFSA. This means the funds are subject to the $20,000 asset protection allowance. And any funds above that limit only affect aid by 5.64%.

But the distributions from these plans are not included in the student's "base year income" at all.

How Grandparent 529 Plans Affect Financial Aid Eligibility

However, 529 college savings plans that are owned by grandparents are treated very differently. In this case, the assets don't count against the student on the FAFSA. That's a nice perk. But the distributions are counted as student income.

Remember, student income is assessed at 50%. This means that for every $10,000 of income that a student receives from a grandparent's 529 plan, it will reduce their financial aid eligibility by $5,000.

For these reasons, it's typically smartest for a 529 savings plan to be taken out in a parent's name. However, only the last two years of a student's income history counts against their financial aid eligibility. So 529 plan income that a student receives in the last two years of school won't affect his or her eligibility for student aid, even if that income comes from a grandparent's 529 plan.

Related: Hacking College With Zero Debt

What Happens To A 529 Plan If It's Not Used?

This is likely the biggest fear of the 529 college savings plan saver. Many people hesitate to open a 529 savings plan because they're afraid all the money will be gone if children arbitrarily decide they're "just not college material."

These fears are understandable. But, in reality, it's not the end of the world if you aren't able to use all of your 529 plan funds on qualified education expenses. First, it's important to remember that 529 plans are post-tax accounts. So all of your contributions can be withdrawn at any time tax and penalty-free. The only money that would be subject to the 10% penalty would be your investment earnings.

Even if you incur a penalty for an unqualified distribution, remember, those earnings will have grown tax-free for years. In fact, in savingforcollege.com's brief look at the penalties of an unused 529 plan, they say that in many cases the 529 penalty may be no worse than investing in a taxable brokerage account. For these reasons, 529 savings plans are a safer choice than prepaid tuition plan if you're worried that your child may decide to skip college.

How Do I Fund A 529 College Plan?

First, you'll want to do your research to decide whether your state's plan would be your best choice or if another state's plan would be more affordable. Once you've chosen a specific plan, you can connect your bank account to make your initial deposit. Most plans also allow for automatic deposit on a monthly, semi-monthly, or quarterly basis.

After you've funded your plan, you'll want to choose how your money will be invested. Keep in mind that actively managed mutual funds tend to have higher expense ratios. To cut costs, look to invest the money in passively managed index funds and ETFs.

Some plans may also offer target-date funds. These could be a smart choice because your asset allocation will progressively become more conservative as you get closer to the date that your son or daughter will be entering college. Coupled with setting up automatic deposits, an age-based 529 plan could truly be a "set it and forget it" option for parents or students.

What Are The Alternatives To 529 College Savings Plans?

There are two main alternatives to a 529 college saving plan. The most popular competitor is the Roth IRA, and the other rival would be the Coverdell ESA. Let's take a look at how the 529 college savings plan compares with both alternatives.

529 College Savings Plan Vs. Roth IRA

On the surface, Roth IRAs bear a lot of resemblances to 529 college savings plans. First, as post-tax accounts, Roth contributions can always be withdrawn tax-free and used however you'd like.

But the Roth benefits actually even go further than that. In most circumstances, if you withdraw any of your Roth earnings before you reach retirement age, the funds will be subject to income tax and a 10% penalty. But the 10% withdrawal penalty is waived when earnings are used to pay for qualified higher education expenses. And that's a big deal.

The biggest difference between these two accounts comes down to contribution limits. You can't contribute more than $6,000 per year to a Roth. But 529 plans generally have no annual contribution limits, only lifetime limits. Second, Roth funds that are used to pay for college expenses are counted as student income. And since student income can reduce student aid eligibility by 50%, that's an important difference that shouldn't be overlooked.

Finally, it should be noted that while the 10% penalty is waived on Roth earnings distributions used for education costs, income tax will still be owed. For most parents, starting with a 529 plan is probably the best move. But if your child gets a part-time job in high school, you could open up a Roth in their name. Until you hit the $6,000 maximum, you can contribute up to 100% of their annual earned income.

Related: How To Use A Roth IRA For College And Other Expenses

529 College Savings Plan Vs. Coverdell ESA

The Coverdell ESA was formerly known as the Education IRA. Like a 529 Plan, it offers tax-free growth and tax-free distributions as long as the funds are spent on qualified higher education expenses. Certain K-12 expenses can also be paid for with Coverdell ESA funds.

One of the biggest benefits of the Coverdell ESA is that it usually offer a high level of investment flexibility. Savers can open a Coverdell ESA with virtually any broker, including self-directed accounts. 529 college savings plans, on the other hand, tend to work more like 401(k)s. In other words, your investment options may be limited.

The biggest downside to the Coverdell ESA--and it's a whopper--is its strict contribution limits. Contributions are restricted to $2,000 per beneficiary per year. This means that if mom, dad, grandma, and grandpa all opened up Coverdell ESAs, the total amount they could save each year per student would still be only $2,000 combined. That's a major drawback that limits the Coverdell ESA's appeal.

However, consider this: There's no reason why you can't have both a Coverdell ESA and a 529 college savings plan. If you'd like to save your first $2,000 in the Coverdell ESA and the rest in the 529 plan, that's perfectly fine. However, if you'd prefer to put all your money into a single plan, the 529 is probably your best choice.

The Bottom Line

The 529 college savings plan is truly one of the most flexible and efficient ways to save for college. You can contribute massive amounts each year and the money grows and can be withdrawn tax-free. Plus, when the accounts are held in a parent's or dependent student's name, 529 plan income has a minimal effect on financial aid eligibility.

Looking for other ways to save for college and reduce college debt? Check out our Ultimate Guide to College Hacking.

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