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  • Writer's pictureAsad Gourani, CFP®

Saving for College: How Do 529 Plans Really Work?

Updated: Jan 18, 2021

How Do 529 Plans Work

Do you know just how expensive college really is these days? The average college tuition for an in-state school for the 2017 to 2018 academic year was a whopping $20,800. Students who choose to pursue a pricier private tuition can expect to hand over an average of $47,000 annually. With rates like these, it makes sense to plan ahead for college expenses. Being prepared years in advance means that you can take advantage of the compounding effect to make this burden a little more bearable. Smart investors are taking advantage of 529 plans because of this compounding effect and its extra bonus – tax benefits!

Let’s take a closer look at just what these plans entail and the benefits you can receive.

What is a 529 Plan?

A 529 is a savings plan specifically designed to assist with the qualified costs associated with college education (and now K-12 school education after the passing of Tax Cuts and Jobs Act in 2018). Each qualified contribution is made with your after-tax dollars and grows on a tax-deferred basis. Not only that, but your qualified distributions are also tax-free. This may sound like a great deal on its own, but there is even more to the story. In addition to these tax benefits, 35 states now offer either a state tax deduction or a tax credit for your contributions.

Each contribution that you make to a 529 plan is considered a gift for tax purposes. You may contribute up to the annual exclusion gift limit of $15,000 per individual into one of these savings plans without incurring any gift-tax consequences. Some individuals prefer to invest all of their funds into these plans in one lump sum. Fortunately, there is a five-year forward gift tax averaging in effect. This means that you could contribute up to $75,000 at once without incurring any gift taxes.

What Effect Does a 529 Have on FAFSA Eligibility?

Many people rely on financial aid to assist with covering the costs of higher education. It is reasonable to wonder exactly what effects a 529 plan will have on your FAFSA eligibility. If a 529 plan is owned by the parents (or a dependent student), the assets are reported as a parent asset and the distributions are ignored entirely.

Generally speaking, this is a more favorable outcome than if the 529 plan was to be counted as the student’s asset. Having student assets reduces the need-based aid by 20 percent of the value of the asset. On the other hand, a parent asset reduces need-based aid by just 5.64 percent.

Limits and Quirks of a 529 Plan

There is no income phase on contributions made to a 529 plan, so anyone is able to contribute. Age limits also do not exist with this type of savings plan. However, there is a very high limit of cumulative contributions that can range from $230,000 to $520,000. This contribution limit is determined by your state.

Students may use the contents of their 529 plan toward tuition and fees, as well as other related education items. They may be used for books, supplies, equipment, and room and board for students who attend at least half-time. As a result of the new 2018 tax cut and jobs act, each beneficiary may also use up to $10,000 annually for K-12 school tuition.

What Happens if Your Child Does Not Go to College?

For many parents and other concerned adults, there is always the fear that the child may not actually attend college when they come of age. If this should happen to you, you can always change the beneficiary to a grandchild, niece, nephew, or other family member. You could also use those funds for your own education.

The worst-case scenario is that you may have to take a non-qualified distribution. Doing so will incur a 10 percent penalty and will tax only the earnings accumulated. The contributions themselves will not be taxed.

How to Choose Your Plan

It is easy to see the benefits associated with one of these 529 savings plans. The accumulated distributions can make your investment worthwhile and help to reduce the financial burden of paying for education. The first step to choosing a plan is to check on the status of tax deduction in your state. You will only be eligible to receive a tax deduction if your particular state offers it and you choose to go with the plan available in your state.

If your state does not offer a deduction, you should look around for the best plan. Compare different investment lineups and the costs associated with them.

Saving for college can be an arduous task that feels impossible. Opening up a 529 savings plan can take some of the hassle out of saving. You can make contributions slowly over the years and even receive tax benefits for doing so.



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