Section 529 plans include both prepaid tuition programs and school savings plans. While prepaid tuition programs have been around longer, it is the school savings plan that is garnering most of the attention these days. Changes to college savings plans enacted several years ago by the Economic Growth and Tax Relief Reconciliation Act made these plans more attractive from a tax-planning standpoint.
Basically, a college savings plan allows you to place money in a state plan to be used for the beneficiary's higher-education expenses at any college or university, which include tuition, fees, books, supplies, and certain room-and-board costs. Your money is invested in stocks, bonds, or mutual fund options offered by the plan, with no guarantee as to how much will be available when the beneficiary enters college. Some of the more significant benefits of these plans include:
- Distributions from Section 529 plans used to pay qualified higher-education expenses are excluded from taxable income. A tax law change made this tax break for qualified distributions permanent.
- While prepaid tuition programs require you to use funds to pay tuition at your state's public colleges, college savings plans allow you to use distributions at any college in the country for a broader range of expenses.
- You are the account's owner and can change the beneficiary or even take the money back, if permitted by the plan. Thus, you can change the beneficiary if your original beneficiary decides not to go to college. If you take the money back, you owe ordinary income taxes on earnings and the 10% federal income tax penalty. The money can be withdrawn without penalty if the beneficiary dies or becomes disabled.
- In 2023 you can contribute up to $85,000 to a qualified plan — $170,000 if the gift is split with your spouse — in one year and count it as your annual $17,000 tax-free gift for five years. However, if you die within the five-year period, a pro-rata share of the $85,000 returns to your estate. Grandparents can set up accounts for grandchildren, transferring large sums from their estates while providing for their grandchildren's education. (In 2022 the gift exemption was $16,000 per year per recipient.)
- There are no income limitations for contributions. Thus, these plans may be of particular interest to higher-income individuals who may not qualify for other college savings strategies.
- The assets in the plan are considered the account owner's assets, not the beneficiary's assets. For financial aid purposes, 5.6% of the parents' assets and 20% of the child's assets are expected to be used for college costs. If the grandparents are the owners, the assets may not even be considered for financial aid purposes. Even though distributions are income tax free, their status for financial aid purposes is not clear. It may come down to a college-by-college decision whether the income will be considered the child's income.
- You can now make tax-free transfers of funds from one plan to another or from one investment option to another for the same beneficiary once every 12 months. In the past, the beneficiary had to be changed to make a tax-free transfer.
Most states now offer college savings plans, with the plans administered by the state or financial institutions. Some state programs only accept residents, but most plans accept participants from any state. Before contributing to a plan, consider these tips:
- Check out your own state's plan first. Many states offer state income tax benefits to residents who contribute to its plan.
- Review investment options carefully. You can't actively control the investments in your account, so you'll have to select from the plan's options. Some plans offer a couple of options, while others offer a more diverse selection. Recently, several plans added a principal-protected or guaranteed-return option to counter concerns about stock market volatility.
- Examine fees. The management fees charged by plans vary widely and can significantly impact your funds' performance. Some plans also charge an enrollment fee, an annual maintenance fee, and other annual expenses.
College savings plans offered by each state differ significantly in features and benefits. The optimal plan for each individual investor depends on his/her individual objectives and circumstances. In comparing plans, each investor should consider each plan's investment options, fees, and state tax implications.
Update: Beginning in 2018, the Tax Cuts and Jobs Act (TCJA) made it possible to use 529 accounts to pay for tuition not just as college, but also at public, private, or religious elementary or secondary schools. The TCJA also allows you to take tax-free distributions of up to $10,000 per year to pay for these education costs.