A 529 is an educational savings plan sponsored by each individual state. The purpose is to offer specific tax benefits and encourage parents to save money for their children’s future college expenses.
Tax Advantages
There are several tax advantages to a 529 plan. Let’s start with the Federal level.
Gains made inside a 529 plan are tax-deferred. That means you do not need to report the profits made within the 529 plan on your annual tax filing. Moreover, as long as the funds from a 529 are used for qualified educational expenses, it is also not taxable at withdrawal. Let’s compare this scenario in the following example.
529
Principle Contribution – $10,000
Growth Rate – 7%
Time – 17 Years
Projected Amount – $31,588.15 (all tax-free)
Brokerage Account
Principle Contribution – $10,000
Growth Rate – 7%
Time – 17 Years
Projected Amount – $31,588.15
Amount Subject to tax – $21,588.15
As you can see, there are a lot of tax savings here. Depending on the parent’s income level, they could save up to $4,317.63 in taxes (assuming 20% long-term capital gains tax rate). Of course, the tax savings will only be higher if additional contributions are made.
There are state tax benefits as well. Like with Federal tax, qualified education withdrawals can avoid any income taxation. Moreover, if you use your home state’s 529 plan, you may be able to deduct your contribution from your state income tax. This is unique since you cannot deduct contributions from Federal taxes. The critical thing to understand is that not every state allows a deduction, and the deductible amount varies from state to state. You must verify this by checking your state’s tax code or consulting a tax professional.
Type of Plans
There are two types of 529 plans. Each has its advantages and disadvantages. I will highlight each one below:
The College Investment Plan
The college investment plan is the most popular. Most states offer this option because of its flexibility and simplicity. You can start small and save as much as your budget allows. You can also set up automatic investments and stop contributions at any time. The plan can cover tuition, books, and other college-related qualified expenses. With the recent tax law changes, you can also use up to $10,000 per year for private K-12 school expenses.
The Pre-Paid Trust
Only a few states offer this plan. As the name implies, you are paying for college tuition before your child goes to college. The benefit here is that you can lock in today’s tuition cost. With college tuition going up by about 8% per year, this can be real savings in the future.
You can select how many semesters you want to pay for and if it is for a university or community college. Then, the plan will pay the tuition as long as your child goes to that state’s school. If they decide to attend an out-of-state or private university, the state will calculate an average tuition cost for the state and forward the amount to the school. You will then be on the hook for any price difference. You will not get any refunds if the college costs less than the average state tuition.
Secondly, the Pre-Paid Trust only covers tuition. Additional expenses such as room and board, book, and other related costs are not included.
Usage
Even though 529 plans are state-specific, it does not mean that you have to go to that state’s schools. You can use the 529 plans at any federally accredited college, certified apprenticeship program, or technical or trade school. You can look up a full listing of eligible schools here. If your child decides not to pursue post-secondary education, you can transfer the account to another child, yourself, or a family member (with limitations). You can also hold the funds in the account until they are ready to pursue higher education. Because the 529 account can stay open indefinitely, you could transfer the account to a grandchild in the future.
Disadvantages of the 529 Plan
The main disadvantage of the 529 plan is that the funds need to be used for education. If the funds were withdrawn for a non-qualified purpose (like a post-graduation trip), gains are subject to taxes and an additional 10% tax penalty.
The 529 investment plan invests in stocks and bonds, which means your funds are subject to market movements and could incur losses.
The 529 plan is a great way to save for college. With the various tax benefits, it is no wonder that it is one of the most popular vehicles for higher education savings. However, suppose you are unsure or do not want the funds to be restricted to educational purposes. In that case, you may want to consider a brokerage or other savings account.
Commonly asked questions:
* Can I use another State’s 529 plan?
Yes, anyone can open a 529 plan that’s not within their home state. However, you will not receive any state income tax deductions, if applicable.
* Can my child go to an out-of-state university?
Yes, they can.
* Can I only use the 529 plan for undergraduate college or degree?
No, with recent changes, you can also use up to $10,000 per year on private K-12 schools. If there are funds left over, you can also use them for graduate school. Lastly, you can also make a one-time payment of $10,000 from your 529 plan towards student loan.
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