A 529 savings plan is a popular way to save for college. Contribution limits are high, qualified withdrawals are tax-free, and the plan's investment funds can grow your money. Here's how much you can contribute to a 529, how big it could grow, and what you need to know if you contribute more than $14,000 in a year.
An introduction to 529 savings plans
529 savings plans are sponsored by the states, and are offered through various financial institutions. While you don't have to use your own state's 529 savings plan, depending on where you live, there may be some tax incentives for doing so. For example, I use South Carolina's 529 savings plan, which allows me to deduct contributions on my state tax return. Here's a great directory from Savingforcollege.com that can show you the benefits of your state's plan, as well as others.
Contributions to a 529 savings plan are made on an after-tax basis on the federal level. In other words, you can't deduct your contributions on your 1040, but any qualified withdrawals for educational expenses will be 100% tax free.
Like a 401(k), 529 savings plans offer an assortment of investment funds to choose from, as well as some options that automatically adjust from aggressive to conservative investment strategies over time. The main advantage of 529 savings plans is that no matter how much your investments grow, you won't have to pay any capital gains tax, as long as the funds are used for qualified higher education expenses.
Qualified expenses include, but are not necessarily limited to, tuition and mandatory fees, room and board, books, computers, and other expenses required for attendance.
How much can you contribute?
There is no annual cap on 529 savings plan contributions; rather, these plans generally prohibit further contributions once the account value reaches a certain amount. For example, the plan I contribute to cuts off contributions when all South Carolina 529 savings plan balances for the same beneficiary reach $400,000.
Because the contribution limits can be so high, it's important to mention the estate tax implications. Contributions to 529 savings plans are treated as gifts for estate tax purposes, and are subject to the same $14,000 annual exclusion as any other taxable gifts. So, large contributions can have an effect on estate taxes. However, a lump sum contribution of up to $70,000 can be treated as made over a five-calendar-year period for gift tax purposes.
How big can a 529 plan get?
There's technically no upper limit, since the account balance depends on the performance of the underlying investments. For example, if you contribute the maximum $400,000 balance to a 529 savings plan right away, the account could easily swell beyond a million dollars by the time the beneficiary is in college, even with so-so investment performance.
For most of us, we're not going to contribute hundreds of thousands of dollars as soon as our children are born. So, here's an excellent calculator that can help you estimate how much you could potentially accumulate in a 529 savings plan, and how much the tax advantages could save you.
Is it right for you?
The 529 savings plan is one of two main types of college savings accounts, the other being the Coverdell ESA. Both have their pros and cons. We've already discussed the 529, but the Coverdell lets you invest in virtually any stocks, bonds, or mutual funds you want, and also allow you to use the money for educational expenses before college, such as private school tuition. The main downsides are the low contribution limit of $2,000 per year and the absence of state tax incentives.
The bottom line is that the right choice for you depends on your situation -- how much you want to save, your investment preferences, and when you want to use the money. Depending on your circumstances, a Coverdell, 529, or a combination of the two could be the best way to go for you.