529 Plan Overview: Are they the Answer to Rising Tuition Inflation?
One of the most requested posts I have received since starting this blog is to cover 529 plans. Why? My take is that many readers of this site are having children for the first time and have bundles of fear around what education costs might be in 15-18 years with the rapid pace of tuition inflation, and no relief in sight.
It’s a valid concern, particularly if you belong in the camp who believes that a 4 or 6-year university degree is a pre-requisite for a decent paying job. According to the US Department of Education, the average annual cost of public school increased 6.5% each year over the last decade. At this pace, by 2030, annual public tuition will be $44,047. The total cost for a 4-year degree will be more than $205,000!
The rapid pace of education inflation for such degrees has led to what will undoubtedly be one of the greatest challenges of the next generation – the student debt crisis.
I do not belong in the camp that feels a 4 or 6-year degree is a necessity to a well paying job, and the ROI can work out to an individual’s disadvantage in some cases. Nevertheless, if a formal college education is a priority for your family (doesn’t have to be just your child), this post should help set the framework.
What is a 529 Plan?
A 529 plan, at its simplest, is a tax-advantaged savings plan designed to encourage saving and investment for future education costs for a designated beneficiary. They are also referred to as QTP’s (Qualified Tuition Programs), and the “529” moniker comes from the section 529 of the IRS tax code they reside in.
There are two types of 529 plans – prepaid tuition and a savings plan – and the differences between them will be covered in greater detail.
529 savings plans are administered at the state level and all 50 states have one. You are free to choose a 529 from any state, however, there may be advantages to staying within your state of residence, as we’ll discuss.
Anyone can set up a 529 plan, and you can name anyone as the beneficiary – friend or family.
Can you Open a 529 Plan for Yourself?
Yes you can. But don’t view it as a tax-advantaged alternative retirement account. More on that later…
What are the Benefits of a 529 Plan?
Some states allow tax deductions on part or all of contributions. 529 earnings are tax-deferred and distributions are tax-exempt (given that they meet IRS criteria). In this regard, they are kind of like Roth IRA’s, with the additional possible benefit of a state income tax deduction.
Before looking out of state, you may want to look within. Many states offer benefits within their plan only to state residents. These can include tax advantages, matching scholarships and grants, protection from creditors, and exemption from state financial aid calculations.
If you are interested in having a beneficiary participate in a post-secondary education in the future, putting away savings now can have a hugely beneficial impact, given the aforementioned rising costs of tuition.
Another major benefit to 529’s is who owns the account – which I’ll detail next.
Who “Owns” the 529 Account?
We recently covered custodial IRA’s for minors. One of the interesting things about custodial IRA’s is that the true owner of the account is the minor. A custodian just manages the account until the minor becomes the age of majority.
529 plans are entirely different, in this regard. Anyone can set up the account and name a benefactor of their choosing. The owner is the individual who establishes the account, and that person has complete control over the plan. This does not change as a minor reaches age of majority.
The beneficiary can also be changed at any time.
Are there Any Disadvantages to a 529?
Contributions to a 529 plan are NOT federal income tax deductible.
Any unqualified distributions are subject to income tax (earnings) and an additional 10% penalty (more on this later).
There is also the possibility that 529 funds used for educational expenses may reduce the student’s eligibility for need-based financial aid.
529 Prepaid Tuition Plan Vs. 529 Savings Plan
|Prepaid Tuition 529||529 Savings Plan|
|How it Works:||You pay now for future education. Price of tuition is locked in at today's prices at participating institutions.||Works more like an investment account where you can contribute and withdraw at the time the benefactor has education costs.|
|Expenses it can be Used Towards:||Tuition & mandatory fees. Some plans allow you to pre-purchase room & board or use excess tuition credits for other qualified expenses.||All qualified education expenses, including tuition, room & board, mandatory fees, books, & computers.|
|State Residency Requirement:||In most states, residency is required.||State residency is not required, although there may be additional benefits (i.e. state income tax deduction) by purchasing in state.|
|Performance/Guarantees:||Most are backed by state government.||Results vary based on market performance.|
|Age Limits:||Most have an age limit.||No age limits. Beneficiary can be any age.|
|Availability:||11 states||50 states|
Which States Have Prepaid Tuition 529 Plans?
All fifty states and the District of Columbia sponsor at least one type of 529 plan. However, only 11 states have a prepaid tuition 529 plan, and that number is dwindling. Most of those require residency in that state.
The following states offer a guaranteed (state-backed) prepaid tuition plan:
The following states offer a prepaid tuition plan, but the terms are subject to change:
529 Income Limits for Contributions
Interestingly, there are no income limits to 529 plan contributions.
529 Plan Contribution Limits
The money you put in a 529 account is considered a gift and, as such, qualifies for the annual $14,000 (2014, 2015) gift tax exclusion. That is, you can contribute up to $14,000 annually (or $70,000 if you carry forward for the next 4 years), per beneficiary, without incurring any gift tax. You can contribute more, but you would incur the gift tax. For more on this topic, check out IRS publication 950.
What Types of Institutions can you Use a 529 for?
Eligible educational institutions generally include colleges, universities, vocational schools, or other post-secondary educational institutions that are eligible to participate in a student aid program administered by the U.S. Department of Education.
529 Qualified Expenses
Funds from a 529 savings plan can be used for:
- mandatory fees
- books & required supplies and equipment
- computer, related equipment, & internet access
- room & board (if at least half-time student)
at any accredited college, university or vocational school in the United States and at some foreign universities.
Funds CANNOT be used towards any sort of student loans or student loan interest.
Prepaid tuition plans have varying rules, but usually cover tuition and mandatory fees only.
Transferring 529 Beneficiaries
Lets say you have a spouse or child that ends up not going to post-secondary school, and you want to change the beneficiary to another family member. This can be done, with no tax consequences.
You can even change yourself to the beneficiary, if your child no longer needs the savings.
And you can roll over funds from one 529 plan to another (i.e. one child’s 529 to another, or a child’s 529 to a spouses), if you’d like.
What if the Funds are Not Used?
This is the big question. What if you contribute thousands, even tens of thousands over the years, only to find out at a later point that the money cannot be used for any beneficiary? What happens to the funds then?
We already covered that you can change beneficiaries.
Beyond that, most plans allow you to reclaim contributed funds for yourself at any time or make yourself the beneficiary. However, as mentioned earlier, any unqualified distributions are subject to income tax on gains and an additional 10% penalty. This does not change over time and 529 plans cannot be converted into IRA’s or other retirement plans.
There are exceptions to the tax and 10% rule if the distributions are:
- Paid to a beneficiary or estate of the beneficiary upon death.
- The designated beneficiary becomes disabled. A person is considered disabled if there is proof that he or she cannot do any substantial gainful activity because of a physical or mental condition. A physician must determine that the individual’s condition can be expected to result in death or continue indefinitely.
- Beneficiary receives education assistance for U.S. military service (distribution must not exceed costs of education).
- Included in income only because the qualified education expenses were taken into account in determining the American opportunity or lifetime learning credit.
- The designated beneficiary receives any of the following:
- a tax-free scholarship or fellowship
- veterans’ educational assistance
- employer-provided educational assistance
- any other tax-free payments (other than gifts, bequests or inheritances) received for education expenses
Are 529’s the Answer to Soaring Tuition Costs?
If you start a plan at the birth of your child and contribute early and often, 529’s can help limit the impact of tuition inflation. However, college education costs can be prohibitively high already – averaging $15,918 per year already for a public institution. One has to hope this bubble bursts sooner than later, or a post-secondary education will be a thing reserve for the financial elite only.
More Information on 529’s
If you are interested in a 529 plan, review all the fine print. Plans differ per state and some state’s plans are inferior to other state’s plans. All plans are not created equal. Also, take a few minutes to review section 8 of IRS publication 970 on qualified tuition programs.
529 Plan Discussion:
- Have you started investing in a 529? Prepaid or Savings? And why?
- Have you invested in a 529 plan from a state other than one you reside in? Which state and why?
- Have you invested in a 529 plan for reasons other than paying for your child’s future education costs?