The ABCs of 529 Savings Plans
The benefits include a variety of investment options and potential tax advantages.
- Alleviate the impact on financial aid.
- Be more flexible thanks to fewer account restrictions.
- Control the money and choose among many investment options.
Whether you've got toddlers, teenagers, or even grandchildren, one thing is certain: Paying for college seems to get more expensive every year. Given that the average annual cost (tuition, fees, and room and board) for a four-year, in-state public college is $21,370 for the 2018–2019 tuition year, and $48,510 per year for a four-year private college,1 it's no surprise that college expenses can be overwhelming.
Footing college bills these days often takes every source of potential funding available to a parent, and there may be no better place to start than by opening and contributing to a 529 savings plan account. Why? The restrictions are few, and the potential benefits can be significant for the account holder, including certain tax advantages, potential minimal impact on the financial aid available to the student, and control over how and when the money is spent.
What's more, tax reform law expanded the value of 529 plans. Now you are able to spend up to $10,000 per beneficiary per year on elementary or high school tuition expenses from a 529 plan.2
Understanding the ins and outs of a 529 savings plan may help you unlock one of the biggest bangs for your education-savings buck.
A 529 savings account offers many advantages
While there are several ways to save for college—such as opening a custodial account (Uniform Gifts to Minors Act [UGMA]/Uniform Transfers to Minors Act [UTMA] account), a Coverdell Education Savings Account (ESA), or even setting money aside in a taxable account (see the detailed chart below)—the potential advantages of a 529 savings plan may help you save for your child's education.
529 savings plans are flexible, tax-advantaged accounts designed specifically for education savings.
You can take withdrawals from a 529 plan to pay for qualified education expenses at the elementary through high school levels, or for college-level and beyond.
At the college or graduate level, funds from a 529 plan can be used for tuition, fees, books, supplies, approved study equipment, and room and board for a full-time student at an accredited institution.
When 529 funds are used for these qualified purposes, there is no federal income tax on investment gains (no capital gains tax, ordinary income tax, or Medicare surtax).
Typically, a parent or grandparent opens the account and names a child or other loved one as the beneficiary. Each plan is sponsored by an individual state, often in conjunction with a financial services company that manages the plan, although you don't have to be a resident of a particular state to invest in its plan.
The ABCs of 529 plan benefits to consider:
A. Alleviate the impact on financial aid
Many families worry that saving for college will hurt their chances of receiving financial aid. But, because 529 savings plan assets are considered parental assets, they are factored into federal financial aid formulas at a maximum rate of about 5.6%. This means that only up to 5.6% of the 529 assets are included in the expected family contribution (EFC) that is calculated during the federal financial aid process. That's far lower than the potential 20% rate that is assessed on student assets, such as assets in an UGMA/UTMA (custodial) account.
This lower rate means that every dollar saved in a 529 college savings plan can go a long way toward helping to pay for college without significantly affecting financial aid for the student.
* For 529 accounts only, the new beneficiary must have one of the following relationships to the original beneficiary: 1) a son or daughter; 2) stepson or stepdaughter; 3) brother, sister, stepbrother, or stepsister; 4) father or mother or an ancestor of either; 5) stepfather or stepmother; 6) first cousin; 7) son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; or 8) son or daughter of a brother or sister. The spouse of a family member (except a first cousin's spouse) is also considered a family member. However, if the new beneficiary is a member of a younger generation than the previous beneficiary, a federal generation-skipping tax may apply. The tax will apply in the year in which the money is distributed from an account.
† In order for an accelerated transfer to a 529 plan (for a given beneficiary) of $75,000 (or $150,000 combined for spouses who gift split) to result in no federal transfer tax and no use of any portion of the applicable federal transfer tax exemption and/or credit amounts, no further annual exclusion gifts and/or generation-skipping transfers to the same beneficiary may be made over the five-year period, and the transfer must be reported as a series of five equal annual transfers on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. If the donor fails to survive the five-year period, a portion of the transferred amount will be included in the donor's estate for estate tax purposes.
†† For 529 savings plans, contributions are considered revocable gifts; owner controls the account; child is the beneficiary. For UGMA/UTMA accounts, contributions are considered irrevocable gifts; distributions must be used for minor; custodian controls the account until it is transferred to the minor at the age of majority. For Coverdell accounts, contributions are considered irrevocable gifts; account owner controls the account; child is beneficiary.
One important caveat is the difference in treatment if someone other than the parents or student—such as a grandparent—owns the 529 plan. In that case, while these 529 savings are not reported as a student asset on the Free Application for Federal Student Aid (FAFSA), any distribution from this 529 plan is reported as income to the beneficiary, potentially resulting in a significant reduction in eligibility for need-based aid the following year. Consider using funds in a 529 plan owned by a non-parent for the last year of college, after the last financial aid forms are filed.
B. Be more flexible
In many ways, a 529 college savings plan has fewer restrictions than other college savings plans. These plans have no income or age restrictions and the upper limit on annual contributions is typically about $300,000 (varies by state). The Coverdell ESA limits contributions to $2,000 annually and restricts eligibility to those with adjusted gross income of $110,000 or less if single filers, and $220,000 or less if filing jointly.
Anyone can open and fund a 529 savings plan—parents, grandparents, other relatives and friends.
C. Control the money and choose among many investment options
Unlike a custodial account that eventually transfers ownership to the child, with a 529 savings plan, the account owner (not the child) calls the shots on how and when to spend the money. Not only does this oversight keep the child from spending the money on something other than college, it allows the account owner to transfer the money to another beneficiary (e.g., a family member of the original beneficiary) for any reason. For example, say the original child for whom the account was set up chooses not to go to college—or doesn't use all the money in the account—the account owner can then transfer the unused money to another named beneficiary.
Each 529 savings plan offers its own range of investment options, which might include age-based strategies; conservative, moderate, and aggressive portfolios; or even a mix of funds from which you can build your own portfolio. Typically, plans allow you to change your investment options twice each calendar year or if you change beneficiaries.
Whatever age-based portfolio you choose, the first step in the process is defining the investment objective.With appropriate, age-based investments, the objective is to grow the assets while maintaining an age-appropriate balance between risk and return.
Think carefully about how you invest your savings. A strategy that's too aggressive for your time frame could put you at risk for losses that you might not have time to recoup before you need to pay for college. Being too conservative can also be a risk because your money might not grow enough to meet costs.
"This is where an age-based strategy may really help people who don't want to actively manage their investments, because it maintains a mix of assets based on when the beneficiary is expected to start college, and rolls down the risk as that time gets closer," says Ridolfi.
Potential tax benefits
If your 529 is used to pay for qualified education expenses, no federal income taxes are owed on the distributions, including the earnings. This alone is a significant benefit, but there are other tax benefits as well.
Gifts to an individual above $15,000 a year typically require a form to be completed for the IRS, and any amount in excess of $15,000 in a year must be counted toward the individual's lifetime gift-tax exclusion limits (the federal lifetime limit is $11,400,000 per individual). With a 529 plan, you could give $75,000 per beneficiary in a single year and treat it as if you were giving that lump sum over a five-year period.3 This approach can help an investor potentially make very large 529 plan contributions without eating into their lifetime gift-tax exclusion. Of course, you could make additional contributions to the plan during those same five years, but these contributions would count against your lifetime gift-tax exclusion limit. Consider talking with a tax advisor if you plan to make contributions exceeding $15,000 a year.
Dispelling 529 Plan Myths
Here are four common myths, and actual truths, about 529 college savings plans:
- 1. If I don't use my 529 college savings plan savings for higher education, I lose the money.
Actually, the money is still yours, but you'll pay both a 10% penalty and ordinary income taxes on the earnings if you don't spend it on qualified higher education costs. To avoid these penalties, you could transfer the account to another beneficiary who plans to go to college. Also, if a child gets a scholarship and you don't need all the money for college, you pay only ordinary income taxes on the earnings portion of the money you take out to offset the scholarship, not the penalty.
- 2. I can only invest in my own state's plan.
Not true. Most plans have no state residency requirements for either the account owner or the beneficiary. Also, most plans have no restrictions on where (which state) you can go to college. It's important to note, however, that some state plans have extra fees for nonresidents that you should consider before deciding to invest with that plan.
- 3. The federal tax benefits associated with a 529 college savings plan will eventually disappear.
The Pension Protection Act of 2006 indefinitely extended the federal tax-free qualified withdrawals on 529 college savings plan savings.
- 4. Once I choose a 529 college savings plan and its underlying investments, I am locked in and cannot make changes.
Actually, you are typically allowed to roll your 529 account savings over to another college savings plan. Additionally, you are allowed to change investments within your plan twice per calendar year or when you change beneficiaries.
Who may want to consider a 529?
Anyone with children or grandchildren likely going to college, whether they are babies or teenagers, may want to consider investing in a 529 savings plan account. The sooner you start, the longer you have to take advantage of the tax-deferred growth and generous contribution limits.
Investors also may want to consider setting up regular, automatic contributions to take advantage of dollar cost averaging—a strategy that can lower the average price you pay for fund units over time and can help mitigate the risk of market volatility. Besides, many investors don't have the financial capacity to make meaningful, lump sum contributions to a 529 college savings plan. Regular, disciplined saving is the most important factor in growing the amount you put away for college
Being smart about the way you save for college also means being mindful of your other financial priorities. "Fidelity believes that retirement saving should be a priority, because while you can't borrow money to pay for retirement, you can for college," Ridolfi says. Still, if college saving is among your financial goals, choosing to invest in a 529 savings plan may be one of the most educated decisions you can make to help pay for qualified college costs.
1. Trends in College Pricing, 2018. College Board Advocacy and Policy Center.
2. Up to $10,000 per taxable year in 529 account assets per beneficiary may be used for tuition expenses in connection with enrollment at a public, private, or religious elementary or secondary educational institution. Although the assets may come from multiple 529 accounts, the $10,000 qualified withdrawal limit will be aggregated on a per beneficiary basis. The IRS has not provided guidance to date on the methodology of allocating the $10,000 annual maximum among withdrawals from different 529 accounts.
3. In order for an accelerated transfer to a 529 plan (for a given beneficiary) of $75,000 (or $150,000 combined for spouses who gift split) to result in no federal transfer tax and no use of any portion of the applicable federal transfer tax exemption and/or credit amounts, no further annual exclusion gifts and/or generation-skipping transfers to the same beneficiary may be made over the five-year period, and the transfer must be reported as a series of five equal annual transfers on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. If the donor dies within the five-year period, a portion of the transferred amount will be included in the donor's estate for estate tax purposes.
An accelerated transfer to a 529 plan (for a given beneficiary) of $75,000 (or $150,000 combined for spouses who gift split) will not result in federal transfer tax or use of any portion of the applicable federal transfer tax exemption and/or credit amounts if no further annual exclusion gifts and/or generation-skipping transfers to the same beneficiary are made over the five-year period and if the transfer is reported as a series of five equal annual transfers on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. If the donor dies within the five-year period, a portion of the transferred amount will be included in the donor's estate for estate tax purposes.
Information is provided by IIS Financial Services and written by Fidelity Viewpoints, a non-affiliate of Cetera Advisors LLC and is considered general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and are subject to change, which can materially affect investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely.
- Information provided in this document is for informational and educational purposes only. To the extent any investment information in this material is deemed to be a recommendation, it is not meant to be impartial investment advice or advice in a fiduciary capacity and is not intended to be used as a primary basis for investment decisions.