529 plans may sound like a great way for parents to save money for college. But what exactly are 529 plans and how do they work? 529 plans are named after Section 529, the Internal Revenue Code. They offer families a tax-efficient way to save for college.
Two types of plans Although 529 plans are named after the federal tax code they are actually managed by states. State rules and regulations vary on investment options, potential returns, tax benefits, fees, and rules. It doesn’t matter if you enroll in the state-managed plan. You can enroll your family in a plan administered by another state and get many of the same tax benefits.
Two types of plans are common in most states:
- You can lock in your child’s tuition with a prepaid tuition program or a prepaid 529 plan. A set price will be charged now, which is less than the tuition cost for your child’s college education. These plans are not available in all states. Many have residency requirements. You must reside in the state in order to be eligible for the plan.
- The college savings program allows you to invest your money after tax, similar to a Roth IRA. Although the plan’s value may fluctuate with the market, your money grows tax-free. No taxes are due when you withdraw the money. Many states also offer tax breaks for the contributions that you make each year.
The best thing about both plans is the fact that family members and friends can contribute to a child’s 529 plan. However, there are dollar limits.
What Education Costs Does A 529 Plan Cover?
The 529 education savings plan provides tax-free earnings growth and tax-free withdrawals for certain educational expenses like tuition and books. You can use the proceeds to pay for room and board. However, there are restrictions regarding off-campus housing.
Some expenses, like student health insurance, are not covered unless they are charged as part of comprehensive tuition or if the fee is required for enrollment or attendance at the college.
- You can also use the education savings plan assets to cover:
- You can pay up to $10,000 annually for tuition at K-12 private schools.
- Graduate and college programs
- Student loans that have a maximum lifetime limit of $10,000 per borrower
What Plan Should I Choose?
A prepaid tuition program can give you peace of mind if the student is going to an in-state university or college. Most likely, all qualified expenses for higher education at an in-state facility will be covered. (The plans structures differ by state so make sure you verify the details. Your prepaid 529 plan will pay a fixed amount depending on the contributions you made if your student selects an out-of-state school. If the cost of the school is higher, either you or your student will need to make up the difference.
You can choose how much and when you want to contribute with a typical 5529 college savings plan. Although the choice is limited, you can also choose where to invest. Although you have greater control than a pre-paid 529 plan, you take on more risk. For example, the tuition of your student is not guaranteed to be paid.
Is My State’s Plan Limited?
All states have a college savings plan that families can participate in, so they are not limited to their state’s. There are many states that have different investment options and fees. This means that other states might offer better plans with higher potential returns and lower fees.
There are two things you need to know:
First, even though many states have plans managed by well-respected companies like Vanguard or T. Rowe Price it is better to invest through a state rather than directly through the fund manager.
Second, many states offer tax breaks for residents of their state. If your state offers tax breaks, and you are planning to invest in an outside-of-state plan for it, be sure to understand the tax implications.
What Are The Drawbacks of Each Type Of 529 Plans
Prepaid tuition plans have their drawbacks.
- It is impossible to predict if your child will attend an out-of-state school.
- You might not get the same investment returns as you would with a college savings plan.
- Qualified expenses often include tuition and fees.
There are also some drawbacks to college savings plans:
- Non-education accounts are not subject to the same risks that investments, such as market volatility and possible losses.
- If money from 529 plans is used for expenses other than education, there can be severe penalties
- There are limited investment options.
What If We Don’t Need The Money Later?
What happens to your 529 plan money if your child does not go to college? What if your child is awarded scholarships but doesn’t have enough money to pay for their 529 plan?
There are many options.
First, the 529 money is transferable. The money can be transferred to another child or relative without any adverse tax consequences.
If your child is awarded a scholarship but doesn’t require the money, the amount can be taken out each year and used for non-educational purposes. The proceeds are subject to tax, but you won’t be penalized for them.
Third, you have the option to withdraw the money and put it towards a non-educational purpose. The proceeds will be subject to taxes and a 10% penalty. Legally, you cannot use money from your 529 accounts for your child’s benefit. If:
- A tax-free scholarship is awarded to the beneficiary
- The beneficiary attends the U.S. Military Academy
- The beneficiary becomes or dies
There is no time limit on how much money you can use.
This post was written by All Seasons Wealth. At All Seasons Wealth, we provide expert advice and emphasize the importance of creating in-house portfolios to personalize your strategy for asset management, financial planning, and cash management. We utilize research and perform market analysis to provide you with wealth management in Tampa. No matter your needs, we can work with you to develop a consulting solution tailored to you.
Any opinions are those of All Seasons Wealth and not necessarily those of RJFS or Raymond James. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment. Past performance may not be indicative of future results.