The Fundamentals of 529 Plans

December 13, 2023

I get a lot of questions from parents and grandparents about 529 plan tax benefits and rules. I love these questions! Planning for something as important as an education is great, and understanding the tax benefits can make a difference. 

I worked my way through college, and although I don’t regret it, it was hard work. So one of the first things I did for my own kids was think about how to help fund their education. I also love that college accumulation planning is one of the services LWP includes for clients.

Just like with other financial matters, the more you know, the better decisions you can make to achieve your goals. So let’s talk about the details of 529 plans. (And, as always, talk to your financial advisor for personalized information! We love talking to you and are here to help!)

What Is a 529 plan?

First and foremost, it’s important to know what, exactly, a 529 is. A 529 plan, officially the Qualified Tuition Program, allows people to contribute to an account to later pay for educational expenses at an eligible institution.

529s can pay for expenses at colleges, universities, vocational schools, or anywhere people can use federal student loans. In addition to tuition, 529s can cover fees, books, supplies, room and board, and equipment needed for apprenticeships.

Though you may hear them called 529 college savings plans, they can also be used for up to $10,000 per year for kindergarten through 12th grade tuition.

How do 529 plans work?

Much like retirement accounts, 529 plans take the money contributed and invest it so the principal grows. People can choose their investment strategy within different plans. 

For example, many plans have age-based strategies, so accounts for children who are very young might be more aggressive, given they have a longer time horizon before the funds are needed for college, while those for children who are older might be more conservative so as to preserve the savings. Some plans even allow you to choose your own set of mutual funds to invest in, if that’s what you want.

Then, when the time comes to pay for educational expenses, the account owner can withdraw money as needed.

What if you don’t use it all?

If you choose not to use the money for educational expenses, a new Secure Act 2.0 provision allows you to roll the money over into a Roth IRA. This is super helpful if a child has leftover money after finishing their education or if they decide college isn’t for them. (Although, make sure to check the list of eligible educational institutions before assuming 529s won’t apply. Apprenticeship programs, for example, qualify for 529 money.)

One caveat to this is that the account must be open for at least 15 years before the money can be rolled over to a Roth IRA, so I strongly encourage people with children in their life to open a 529 when the kids are small!

Another option for leftover money is to transfer it to another eligible 529 account. Take for instance someone who has two daughters. One has finished college and has money left in her 529. The other is in her senior year of college and will not have enough money in her 529 to cover all her expenses. The parents can transfer money from the older daughter to the younger daughter, so the money will still be used. 

The IRS allows money to be transferred tax free to members of the beneficiary’s immediate family, such as siblings (including stepsiblings), parents, spouse, children, first cousins, nieces, and nephews. 

Who can open a 529?

Anyone can open and fund a 529 plan – parents, grandparents, aunts, uncles, even a close friend. All they have to do is specify who the beneficiary is (i.e., the child who will receive the income when they are in school). 

One thing a lot of families do is have one person open the account, and then anyone who wishes to contribute does so directly to that account. That can simplify things by having only one account, instead of a lot of smaller accounts floating around. I know some people who, when family members ask for gift ideas, request contributions to the 529 account. 

What are the tax benefits?

If a 529 plan is used to pay for eligible educational expenses, no federal income tax is owed on the distributions, including the investment earnings. 

Contributions to a 529 also have estate planning benefits. Such contributions are considered completed gifts, so they come out of your estate, even though the money can remain under your control (if you are the account owner). 

Of course, talk to a financial professional to understand your specific tax implications. 

Are there state differences?

529 plans are sponsored by individual states, and states offer different benefits. However, you do not need to be a resident of the state to open a 529 plan there, and you do not have to use the plan in that state. That is, if you are a Minnesota resident, you can open a 529 plan for your grandchild (who also lives in Minnesota) in Utah, and your grandchild can go to college in Florida, all without any penalty. 

Talk with your financial advisor about the different benefits of various plans to find the one that best meets your needs. 

Are there alternatives to 529 plans?

There sure are! Although I personally am a fan of 529 accounts, there are other options to consider. 

Coverdell Education Savings Accounts. These work much like a 529, but with a wider array of investment options. There are some limitations, however. Contributions can only be $2,000 annually, and your modified gross adjusted income can’t exceed $110,000 for single filers or $220,000 for people filing jointly. Also, the money you contribute is not tax deductible. Before 529s could be used for primary or secondary education, these were popular, as they could be used for elementary and high school. Now, however, 529s also can be used for those grades. 

Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA). This option is to create a custodial account for a minor and then transfer money using these acts. The money in these accounts must be used for the benefit of the child, but not necessarily for educational expenses, so they are a good option for people looking for flexibility. However, contributions are not tax deductible, and the account’s earnings are taxable. Also, they are considered assets of the beneficiary, so they will be part of the calculation of federal financial aid eligibility when they are in college. (529s, by contrast, are considered parental assets and so have less impact on aid eligibility.)

Helping a child in your life pay for their education is an incredible gift, and there are ways to make that gift work for your circumstances (and theirs). Whether it’s a 529 plan or some other option, you can find ways to invest in a child’s future, while possibly reaping the tax advantages yourself.

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