Saving for college is important in order to keep your children from facing huge amounts of debt as young adults, and setting up a 529 plan is a great way to take advantage of favorable tax provisions that can make your college savings grow quickly. However, in order to take advantage of 529s, you need to know the basics.
In this clip from Industry Focus: Financials, Motley Fool analyst Gaby Lapera and Director of Investment Planning Dan Caplinger discuss 529 plans in great detail, including the pros and cons and requirements for having a 529 plan. As Dan and Gaby describe, the right 529 plan can be a huge asset in your strategy to get your kids through college.
A full transcript follows the video.
This podcast was recorded on Aug. 29, 2016.
Gaby Lapera: Let's start with one of the most popular plans that there is out there, which is the 529 plan. These are called qualified tuition plans legally by the government. The reason they're called 529 plans by everyone else is because they are governed by section 529 in the tax code. Do you want to tell us a little bit about how those are structured, Dan?
Dan Caplinger: Basically, 529 plans are generally offered by institutions authorized by each state. There's more than 50 different plans out there. What many people don't realize is, just because your state offers a plan, that doesn't mean you have to stick with that plan. A lot of people go outside of their state to get a plan.
Basically, what the 529 plan lets you do is, it lets you contribute to this educational account. As a result of that, the investment income inside of the 529 doesn't get taxed along the way. It's tax-deferred, a lot like a 401(k) plan for retirement, except this is going for education. And then, at the end of the day, if you use that 529 plan for qualified educational expenses, you don't have to pay any taxes on any of the earnings. So, it's a really good deal for tax savings in order to help you save and invest long term for that 18, 19 years that you're accumulating money to put your kids through college.
Lapera: Just to be clear, contributions are not deductible, but earnings are exempt from federal taxes and a lot of state taxes, that's going to vary from state to state.
Caplinger: That's exactly right. It's not like a 401(k) in the sense that contributions don't get you an up-front tax break. But what they do get you is, when you make those withdrawals later on, you're going to be eligible for tax-free treatment for those earnings. And you're absolutely right. Some states, if you're a resident of that state, you can get some state income tax benefits as well. Some states actually do let you deduct your contribution or a certain amount of contribution against your state income tax, not against your federal tax, though.
Lapera: Yeah. And just to be clear, this is something that someone was asking me the other day. If you are, say, a resident of Montana, but the Maryland 529 plan looks good to you, you can open one up in Maryland, and your kid can go to school in North Carolina and use it. It doesn't really matter where you are, you can still use these plans.
Caplinger: Absolutely correct. The way that the 529 plan is, it's sort of misleading and some ways, because those state names make it sound like you're going to have to decide when your kid is two years old, "Oh, they'll probably go to school in North Carolina, so I'll get the North Carolina plan." No. They don't want you having to pre-commit. So, the bulk of 529 plans now are totally portable. They let you use the money for any educational institution, as long as it qualifies as a legitimate college or university, they let you use that in pretty much any way that you see fit, anywhere you want.
Lapera: Question for you: Is there a contribution limit on the 529 plans?
Caplinger: There are contribution limits, but they're usually very high. They vary from state to state. In general, you can contribute as much as, generally between $200,000 and $300,000 over the course of all of your savings for one particular child in a given 529 plan. For practical purposes, it's virtually unlimited for most people, in terms of how much you contribute to a 529. Now, the timing of those contributions does make a difference. There are gift tax implications. So, it's something you should pay attention to in terms of putting maximum amounts in on a yearly basis. That can get complicated in a hurry. But the general rule of thumb is, if you're putting $14,000 or less in a 529 plan in any given year toward any one child, then you're perfectly fine.