Should I use a 529 plan to save for college?

Many parents ask, “Should I use a 529 plan to save for college?” Qualified tuition plans, also known as 529 plans, are a popular education savings method that feature special tax benefits. 

How 529 plans work

Anyone can contribute money to a 529 plan on behalf of a beneficiary (student). Contributors are not subject to income limitations, nor are there restrictions on the beneficiaries age. The only requirement is that amounts accumulated in the plan must be used to pay for qualified educational expenses of an undergraduate or graduate program at an accredited institution. Expenses that qualify include tuition, fees, books, supplies, required equipment, and room and board. 

Requirements and Benefits

Among the benefits of a 529 plan are the following: 

• No federal income tax. According to section 529 of the Internal Revenue Code (how 529 plans got their name), earnings from plan investments are free from Federal income tax, as long as the funds are used to pay for qualified education expenses. 

• Tax free growth. Because earnings in 529 plans are not subject to federal or state taxes, the wind is at your back as assets in the account grow. The tax advantages of a 529 plan could mean the difference between fully funding a higher education and coming up short.

• Gift Tax and Estate Tax Benefits. 529 plans are partially exempt from the gift tax. You can contribute up to $14,000 ($28,000 for married couples) annually per beneficiary, or up to $70,000 ($140,000 for married couples) over a five-year period, without triggering the gift tax. Keep in mind that your gifts are excluded from your estate, so investing in a 529 plan can be a smart strategy to reduce your estate tax.

These benefits, coupled with large contribution maximums ($370,000, per beneficiary, in the Texas College Savings Plan), make 529 plans attractive savings vehicles. However, if you use the money for anything other than qualified educational expenses, you face a 10 percent penalty tax and a tax on the earnings subject to that distribution. Special exceptions apply if the student receives a scholarship, dies, or becomes disabled.

How 529 plans affect financial aid

Assets in 529 plan accounts owned by a dependent student or one of their parents are considered parental assets on the Free Application for Federal Student Aid (FAFSA). When a school calculates the student's Expected Family Contribution (EFC), only a maximum of 5.64% of parental assets are counted. This is quite favorable compared to other student assets, which are counted at 20%. The higher the EFC, the less financial aid available. Assets held in a 529 account owned by a grandparent, other relative or anyone else besides a dependent student or one of their parents, will have no effect on the student's FAFSA.

Spending the money

It’s important that withdrawals you take from your 529 college savings account match with the payment of qualifying expenses in the same tax year. Like some families, you may choose to pay the school directly from your 529 account for ease in recordkeeping and matching distributions to school expenses. In this situation, make sure you are aware of school payment deadlines and the time required to transfer funds from the 529 account to the school. It can take several days for investments to be sold out of your 529 account and mailed to the school.

Or you may choose to move money from your 529 account to your bank or brokerage account. Many colleges prefer payments to be made electronically through their website from a bank or brokerage account. You can choose to pay bills first and then reimburse yourself from the 529 account, or you can pull money from the 529 account and then use it to pay bills from your bank or brokerage account. This path also provides flexibility when paying smaller bills like those for books.

Keep in mind that you must submit your request for the cash within the same calendar year—not the same academic year—as you make the payment. If the timing is off, you risk owing tax because it’s considered a non-qualified withdrawal.

Learn more

A.D. Financial Planning recommends saving for college during step 8 of the 10 steps to Financial Freedom. If you would like to learn more about saving for college, contact us!