529 Plan Basics: Pros, Cons and Strategies

One strategy that many families use to save for college is to invest in a 529 plan.

What is it? A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

There are several pros and cons to investing in a 529 plan:

Pros of a 529 plan include:

  1. High Contributions. 529 plans let you make a higher annual contribution than most other savings plans.
  2. Tax Advantages. A 529 plan provides federal tax-deferred savings and tax-distributions as long as it covers qualified expenses like tuition, books, supplies etc. Some states (but not all) offer tax incentives to investors as well.
  3. Availability. 529 plans do not have age or income restrictions and can pay for certain expenses at both public and private colleges.

Cons of a 529 plan include:

  1. Limited Options. 529 plans generally only offer mutual funds rather than stocks or bonds, and you can’t transfer stocks and bonds into a 529 plan without liquidating them.
  2. Potential Penalties. If you use the funds for expenses that are not related to education, you will likely need to pay income tax and a withdrawal penalty on the funds you use. You also need to use the money before the beneficiary reaches the age of 30 to avoid additional fees.
  3. Impact on Financial Aid Qualification. A 529 account owned by a parent for a dependent student is reported on the federal financial aid application (FAFSA) as a parental asset. Parental assets are assessed at a 5.64% rate in determining the student’s Expected Family Contribution (EFC).

If you do choose to invest in a 529 plan, there are a few strategies to keep in mind:

  • Know whether your family is likely to qualify for financial aid. Many families qualify for more financial aid than they ever thought possible. For example, a family with 2 students attending $50,000 private colleges and over $200K of income could qualify for financial aid. Make sure you know whether financial aid will be in your college planning strategy BEFORE choosing where you will save for college.
  • Don’t withdraw too much or too little. If you take too much money out of your account, you’ll need to report the amount that isn’t used towards qualified higher education expenses as taxable income and pay a 10% federal penalty tax on it. But you don’t want to have money left over in your 529 account after your child graduates, either. If you have money left over you’ll need to pay income tax and a 10% penalty on it.
  • Withdraw in the correct year. The funds you take from your 529 account need to match up with the same calendar year you pay for the qualifying expenses (like tuition).
  • Research school policies before requesting payment be made directly to them. Some schools factor 529 money into their financial aid process, so if the funds go directly to them it might factor into the amount your student receives in federal and school-based grants. Call them first to find out how they handle 529 money so you know whether to request the funds be paid to the school or directly to you.
  • Invest in multiple 529 accounts. Some parents prefer an out-of-state plan to the in-state plan, but they don’t want to miss their in-state tax deductions, so they make contributions to their local plan and then add the remaining money to their out-of-state plan. This can help you diversify and receive the benefits of multiple states’ plans. Just make sure you withdraw from the correct 529 account when you reach that point.
  • Communicate with family. Some children are the beneficiary of multiple 529 accounts with different owners like parents, grandparents, etc. Make sure you talk to other family members well in advance of when you need the money to use the various 529 accounts in the best way possible.

Want to know more about using 529 plans to pay for college? Contact Westface College Planning for additional information!

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