It's expensive to provide an education for your children, and parents need all the help they can get to build up an adequate nest egg to pay for college. With students owing roughly $1.2 trillion in total student loan debt, the payoff from being able to give your kids the education they need without a financial burden they can't overcome is bigger than ever.
529 plans offer a way for parents to save, and when you translate the Internal Revenue Code section that authorizes college savings plans into a calendar date, it's natural that May 29 became known in the industry as 529 Day. These plans have a number of valuable benefits, and although they do have some pitfalls, they generally make good ways to set money aside toward future educational costs. Here are some reasons to look more closely at 529 plans along with some key details you need to know.
1. Get tax-free growth
The most important benefit of 529 plans is the tax-free growth they offer. You put after-tax money into a 529 plan, but if you use it for qualifying educational expenses, then you never have to pay taxes on any of the income or gains that the plan assets generate between the time you invest and when you withdraw money. Only if you end up pulling money out for purposes other than education do you face the potential of having to pay tax on the growth in the account, along with an additional penalty.
Some people advocate for alternatives like Roth IRAs for college savings. Roths also offer the chance at tax-free growth, but the extra benefit of using a 529 is that you don't end up shortchanging your own retirement by using 529 money rather than tapping your IRAs. That's a common problem parents face, and it's best to avoid it by keeping educational savings separate from retirement savings.
2. Extra tax benefits (but be careful)
In addition to tax-free treatment federally, some states add income tax breaks at the local level as an extra incentive. For instance, it's common for states to allow a state income tax deduction up to certain maximum amounts for contributions to that state's 529 plan. These tax savings can add to the already attractive features of a certain 529 offering.
However, it's important to understand that there's no requirement that you use your own state's 529 plan. Sometimes, even if your state gives you a tax break for contributions to your home-state plan, you can do better over the long run by choosing another plan. That's especially true if your state's plan has extremely high costs or weak investment options that don't match up with your needs. Be sure to compare plans to see if whether the tax savings are really worth it.
3. The ability to change beneficiaries (if you need to)
Some parents worry about what happens if they save too much in a 529 plan. Fortunately, the rules give you a couple of options, depending on the situation.
If it turns out that your child got a scholarship and therefore doesn't need the money you saved, then you're allowed to withdraw up to the full amount of the scholarship from your 529 on a penalty-free basis. You'll still pay taxes on the rise in value, but that's a small price to pay in exchange for the windfall of not having to pay for the college education you expected.
Another option you have regardless of whether a scholarship's involved is to change the beneficiary on the 529. For instance, if you have two kids, and your first child uses less money than anticipated, you can take the remainder and switch the beneficiary to your second child. You can generally name any beneficiary you want, so getting nieces and nephews, grandkids, or even close friends of the family involved can be options for some people.
4. Extremely high contribution limits
Compared to other tax-favored accounts, you won't find a better deal than the 529 plan. Maximum contributions vary by state, but it's not uncommon to see lifetime limits in the $300,000 to $500,000 range.
One thing to remember is that contributions to 529 plans are treated as gifts to the beneficiary. That means that contributions above the current annual exclusion amount of $15,000 can be subject to gift tax. Most people will have a lifetime exclusion amount available to avoid any actual tax owed, but the requirement to file a gift tax return is something many people aren't aware of. Also, you have the option of combining five years' worth of annual exclusion gifts into a single year for 529 purposes if you so elect.
5. Expanded use for pre-college costs
Finally, 529 plans recently got an upgrade. Tax reform changed the rules to allow the use of 529 plan money for elementary and secondary educational costs, helping those who pay for private or parochial school education from pre-kindergarten through 12th grade. For those who expect to make substantial payments for as long as a dozen or more years prior to high school graduation, the tax benefits of a 529 can really add up.
Get educated about 529s
529 plans have a lot of advantages that other savings vehicles lack. If you don't know about 529 plans, May 29 is a great day to get the latest scoop and find out whether the college savings plan is the right fit for your financial needs as a parent.