How You Can Use a 529 Plan To Save Money On Taxes While Your Student Is In College or High School
Learn about 529 tax plans and how you might be able to use one.
Next to buying a house, paying for college is one of the biggest financial investments most families will make. If you’re looking for a way to save for your child’s future education costs, a 529 plan is a great option with tax benefits as well. However, 529 plans also have strict rules for how funds can be used. Keep reading to learn what 529 plans are and how they work, so you can save money on taxes for qualified education expenses.
What is a 529 plan?
Also known as Qualified Tuition Programs, 529 plans were created in 1996 when Congress established Section 529 of the Internal Revenue Code. In 2001, Congress made education distributions from 529 plans tax-exempt. Today, all fifty states and the District of Columbia offer at least one type of 529 plan. Private colleges and universities can also sponsor 529 plans.
Like a 401(k) or IRA account, a 529 plan is a tax-advantaged savings account. Instead of encouraging savings for retirement, 529 plans help families save for the future education costs of their children. Because they provide tax-free investment growth and qualified withdrawals, parents may be able to use 529 accounts to save money on federal taxes. Some states offer a state income tax deduction on 529 contributions.
Prepaid Tuition Plans vs. Education Savings Plans
There are two types of 529 plans to know about and choose from:
- Prepaid Tuition Plans: Purchase tuition credits at today’s rates for designated public and private schools with after-tax dollars. Essentially, prepaid tuition plans are designed to protect you from rising tuition costs by “locking in” your rate now. There is also some portability available if your child wants to attend a school not designated by the plan or decides not to attend college at all.
- Education Savings Plans: This is a type of savings account with tax benefits similar to a Roth IRA. Contributions are not tax-deductible, but withdrawals (including investment earnings) are tax-free as long as they are used for qualified education expenses. Some states may exclude contributions from your taxable income at the state level.
Compare and Contrast Prepaid Tuition vs. Education Savings Plans
Understand the key differences between the two types of 529 plans:
- Room and Board: Only funds from education savings accounts can be used to pay for a student’s room and board costs. Prepaid tuition plans cover only tuition and mandatory fees.
- Residency Requirements: Most prepaid tuition plans have a state residency requirement for both the saver and beneficiary. On the other hand, only a few education savings plans have residency requirements.
- Guarantees: Prepaid plans are set up as a contract with a projected rate of return. Most states guarantee that your funds will keep pace with tuition costs. Some prepaid plans are backed by the full faith and credit of the state, whereas others are not. Education savings plans are investments, so there is a possibility of loss just as there would be with any investment account. You can choose from more aggressive or conservative mutual funds to match your risk tolerance.
529 Plan Rules
Because 529 plans come with tax advantages, there are rules for how funds can be used and what qualifies as an education expense. Learn more about 529 plan rules:
1. You can choose a 529 Education Savings Plan from any state.
If your state offers an income tax deduction for investing in its Education Savings Plan, then it’s probably your best bet to go with that option. However, if there are no state tax benefits attached to your state’s 529 plan, you may want to shop around to see if there is a better deal elsewhere. This applies to savings plans only; prepaid tuition plans usually have a residency requirement.
2. The account holder maintains ownership.
As the owner of the 529 plan, funds remain under your control even when the account beneficiary turns 18. This means you can withdraw funds from your 529 plan at any time, though taxes and penalties may apply if the distributions aren’t used for qualified education expenses.
3. There are no contribution limits.
Unlike other types of tax-advantaged savings accounts such as IRAs, 401(k)s, and HSAs, the IRS doesn’t set annual contribution limits on 529 plans. Instead, the general guideline is that total contributions to the account should not exceed the amount necessary to cover the beneficiary’s qualified education expenses. Individual states may set total contribution limits, however, so check your plan details.
Just keep in mind that contributing more than the gift tax exclusion (currently $16,000) to a single beneficiary’s 529 plan could have tax consequences.
4. Pay attention to the rules for qualified distributions.
What counts as a qualified higher education expense? As mentioned above, funds from prepaid tuition plans can only be used to cover a student’s tuition and mandatory fees. There is more latitude with an education savings plan, but you still need to be careful. Other education-related expenses that you can pay for from your 529 plan include:
- Room and board
- “Peripheral equipment” such as a printer
- Private or religious school tuition for elementary, middle, and high school students.
Non-qualified withdrawals from investment earnings will incur a 10% penalty and be subject to income tax. The penalty doesn’t apply to withdrawals from the principal, though they will still be taxed if used for non-qualified expenses. You can also change the account beneficiary if need be so that, for example, if an older child decides not to go to college, a younger sibling can become the 529 plan beneficiary instead.
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Opening a 529 plan will help you save for your child’s future education expenses. You can also benefit from tax-free investment growth while saving money on taxes when you make qualified distributions in your student’s high school or college years. However, sometimes savings alone aren’t enough to cover the full cost of college. If you need to finance part of your child’s education with student loans, join Juno today to find the best private student loan rates and terms. It’s free and fast, with no credit check required to view our negotiated deals. We use group buying power to get you the best student loan interest rates, and our partner lenders offer student loans without any fees. If by some miracle you find a better deal, we’ll beat it!
Elizabeth Helen Spencer is a personal finance and travel writer based in the Philadelphia area. She holds an MFA in Creative Writing and has been featured in Money Under 30 and HuffPost.
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