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The 401(k) of College Savings: 529 Plan Must-Knows

By Sam Swenson, CFA, CPA – Oct 7, 2020 at 9:06AM

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Make sure to get started early on college savings to avoid a high degree of stress later.

401(k) plans for retirement and 529 plans for college savings share some broad characteristics: Put money in today, get a tax deduction, and allow funds to grow tax-deferred for a specified purpose in the future. Still, those who benefit most from 529 plans are those who have taken the initiative to read the details and understand them completely. Equipping yourself with this knowledge allows you to fund your children's college education without stress, even if it's a funding goal situated many years in the future. Here, we'll explore a few unique attributes of 529 plans. 

Anyone can contribute, but parents should own

Generally speaking, anyone (grandparents, aunts and uncles, other relatives) can contribute to a 529 plan. Tax benefits vary by state -- some require that the tax benefits accrue to the account owner, and others allow the contributor to receive the deduction. There's no limit to the number of 529 accounts for a particular beneficiary, meaning tax benefits for 529 contributions can be widely accessed.

529 plan document with glasses, pen, and mortarboard

Image source: Getty Images.

The 529 is best utilized as a parent-owned account, rather than a grandparent-owned account. This will limit the degree to which financial aid is affected: if a grandparent owns the 529, withdrawals are considered income to the student, which can have the effect of reducing financial aid. If a parent owns the 529, only a minimal amount of the account is considered in any financial aid calculation. 

You can contribute more than $15,000

Many people know the $15,000 limit with regard to gift taxes: Gifts from an individual to a non-spouse are limited to $15,000 before gift taxes are triggered. If you're married, you can give up to $30,000 to another individual without gift taxes, as this amount is assumed to be split between you and your spouse. Because contributing to a 529 plan for your child is considered a completed gift, you'll need to be aware of these limits. Once money is in the 529 plan, you're able to select an investment asset allocation to allow for growth over time. 

529 plans, uniquely, also allow you to make a five-year election that treats your contribution as if it were made over five years. In other words, if you contribute $150,000 in the year your child is born, this can be treated as if you and your spouse each contributed $30,000 to the plan for the current year and each of the next four. This allows you to avoid federal gift taxes by adhering to the prescribed limits, and also will likely produce some state tax benefit which will vary by your state of residence.

Know how to exit gracefully

Historically, it's been a baseline assumption that going to college is a necessary experience of young adult life. The next several decades could potentially be different. With the advent of online learning and wide availability of entrepreneurial opportunity, I don't consider college to be a default option for all young people. It stands to reason that many will still opt for college, and many certainly should -- but there are also going to be increasing opportunities to take nontraditional paths that are entirely legitimate and profit-producing. 

With that said, provisions of the SECURE Act allow 529 plan funds to be used for apprenticeships in the trades, repayment of student loan debt subject to a $10,000 lifetime limit, and private K-12 education subject to a $10,000 annual limit. This allows money previously earmarked solely for college to be used for other purposes, which acknowledges the idea that our world is changing rapidly and people need added flexibility. Therefore, if you decide to contribute maximally to your state's 529 plan, you'll have opportunities to use the money for education-related purposes even if your child doesn't attend a formal classroom setting.

Despite the above, keep in mind that money withdrawn for purposes other than those specifically outlined in your state's plan (non-qualified expenses) is generally taxed at ordinary income rates plus a 10% penalty. 

Investigate your state's plan 

For most families with children, 529 plans provide an advantageous medium to save and invest for college while also providing some slack for those who take nontraditional paths. It's nonetheless imperative to read the fine print of your particular state's plan, and to simply know the details before you make contributions. The best advice here is to do this well in advance of needing the money, which will not only provide more time for tax-efficient growth, but will provide greater peace of mind in the years leading up to college.

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