Why choose a 529 plan?

Do you aspire to help your child or grandchild get a good start in life while also ensuring your own future lifestyle? You may want to consider a 529 plan, which could be a tax-advantaged way to save for education costs over time. Allowing funds to accumulate over the years may mean you won’t have to tap into savings or take out loans when the time comes for a younger family member to start college.

Income tax advantages

There are three federal income tax advantages to 529 plans that make these accounts so popular. 

1. Earnings on the investments in a 529 account can accumulate free of federal and state income tax.

2. Distributions from the account are not taxed as income at the federal level and in many cases, the state level, as long as the withdrawals are used to pay qualified higher education expenses like tuition, books and fees, as well as room and board (if the beneficiary is enrolled at least half-time) for the beneficiary of the plan.
3. The tax bill passed at the end of 2017 expanded the tax advantages of 529 plans to include K-12 tuition expenses, allowing for annual tax-free withdrawals of up to $10,000 for private, public or religious school tuition at eligible institutions per beneficiary, per year. While the law expands the definition of “eligible education expenses” for purposes of federal tax law, individual states have their own rules for purposes of state tax law. Many states incorporate part or all of the federal tax code, but check with your tax advisor to be sure.

Look into state tax breaks

States sponsoring 529 plans may offer tax benefits on contributions, including income tax deductions, tax credits and other potential benefits, such as matching grants. If your state of residence (or in which you pay taxes) offers tax breaks, you often are required to invest in a plan sponsored by that state to be eligible for those benefits.

A small number of states allow a tax benefit for contributions to any 529 plan, even out-of-state plans. If this is the case in your state, then you’ll be free to compare plans from across the U.S. and still take advantage of the tax benefit. Check with your tax professional to find out more about your state’s rules.

Compare plan investments

529 plans, though sponsored by a state, are usually managed by a brokerage firm, mutual fund or other financial services company. Look for plans that offer a wide variety of investment portfolios that are appropriate for your investing time frame and risk tolerance.

Many plans also offer investments that automatically move to more conservative holdings as your child approaches college age.

Better late than never

Ideally, you’ll be able to enroll in a plan while your child is still very young, with a low minimum contribution that will give your money a longer period of growth potential. 

If you weren’t able to start putting funds aside until your child was older, you can give your savings a turbo boost by “frontloading” a 529 plan. In 2022, this allows you to contribute up to $80,000 per child in the first year of a five-year period without triggering federal gift tax consequences (instead of contributing the annual gift tax exclusion limit of $16,000 per child per year based on 2022 limits). If you and your spouse both contribute, the total amount allowed can be as much as $160,000.

As far as gift tax is concerned, the contribution would be treated as if you gave $16,000 per year for each of five consecutive years. If you “maximum fund” under this rule, you generally can’t make additional taxable gifts to the beneficiary until the five years are over without triggering gift tax consequences – unless the annual gift tax exclusion amount increases. If you die prior to the end of the five-year period, a portion of the contribution will be included in your estate for federal estate tax purposes.

Use it for yourself

Planning to attend classes to further your career or return to school in retirement? While most people think of a 529 plan as an investment tool for a kids’ or grandkids’ education, you can also use the savings to pay for your own higher education costs. You’re allowed to make yourself the beneficiary of any unused funds in your child’s account or set up an entirely new plan in your own name.

Your financial advisor can help you compare 529 plans available in your state, as well as the fees and expenses associated with the various plans. Be sure to work with your tax accountant early in the process as well.

For more information on 529 plans and a plan comparison tool, go to Savingforcollege.com.