Given that the average annual cost (tuition, fees, and room and board) of college has increased 11% at public colleges and 14% at private colleges (over and above increases in the Consumer Price Index), it’s no surprise that college expenses can be overwhelming. In the 2021-2022 year, the average total cost of attendance for in-state students at public colleges was $27,330; and over double that amount for private colleges at $55,800. When it comes to footing college bills these days, there may be no better place to start than by opening and contributing to a 529 college savings plan.
The advantages of a 529 college savings account
Understanding the ins and outs of a 529 college savings plan may help you unlock one of the biggest bangs for your college-savings buck. Their benefits include:
- Few restrictions
- Tax advantages
- Potential minimal impact on financial aid
- Control over how and when the money is spent
Designed specifically to help pay for qualified costs associated with higher education, a 529 college savings plan is a tax-advantaged account that allows distributions to pay for things like tuition, fees, books, supplies, and any approved equipment the student may need to study at accredited institutions. In addition, you can take distributions for room and board, as long as the beneficiary of the plan is attending the school at least part-time. When 529 funds are used for these qualified purposes, there is no federal income tax on investment gains (no capital gains tax, ordinary income tax, or Medicare surtax).
Typically, a parent or grandparent opens the account and names a child or other loved one as the beneficiary. Each plan is sponsored by an individual state, often in conjunction with a financial services company that manages the plan. However, you don’t have to be a resident of a particular state to invest in its plan.
The ABCs of 529 plan benefits and details
A. Alleviate the impact on financial aid
Many families worry that saving for college will hurt their chances of receiving financial aid. But, because 529 college savings plan assets are considered parental assets, they are factored into federal financial aid formulas at a maximum rate of about 5.6%. This means that only up to 5.6% of the 529 assets are included in the expected family contribution (EFC) calculated during the federal financial aid process. That’s far lower than the 20% rate of student assets considered, such as funds in a UGMA/UTMA (custodial) account. This lower rate means that every dollar saved in a 529 college savings plan can go a long way toward helping pay for college with a relatively small impact on the student’s eligibility for financial aid.
One important caveat is the difference in treatment if someone other than the parents or student—such as a grandparent—owns the 529 plan. In that case, while these 529 savings are not reported as a student asset on the Free Application for Federal Student Aid (FAFSA), any distribution from this 529 plan is reported as income to the beneficiary, potentially resulting in a significant reduction in eligibility for need-based aid the following year. If they’re available, consider using funds in a 529 plan owned by a nonparent for the last year of college, after the last financial aid forms are filed.
B. Be more flexible
In many ways, a 529 college savings plan has fewer restrictions than other college savings plans:
- No income or age restrictions
- Anyone can open and fund a 529 college savings plan—parents, grandparents, other relatives and friends
- You may even open one to pay for your own college expenses
- No upper limit on annual contributions (unlike the Coverdell ESA, which limits contributions to $2,000 annually and restricts eligibility to those with an adjusted gross income of $95,000 per year for a single tax filer, or $190,000 per year for joint filers).
There are limits, however. Once a 529 plan account reaches a certain value—ranging from $235,000 to $550,000 (limits vary by state)—further contributions are not permitted.
A 529 can also be used for private school tuition (K-12)
In some states, you can pay your child’s private school bill from savings accounts usually used for college tuition. You can take a tax-free distribution from your 529 savings plan of up to $10,000 per student per year. This amount can be used to pay tuition for kindergarten to 12th grade at a private school. Although tuition can be paid from multiple 529 plan accounts, the total amount can’t exceed the total annual limit.
C. Control the money and choose from many investment options
Unlike a custodial account that eventually transfers ownership to the child, with a 529 college savings plan, the account owner (not the child) calls the shots on how and when to spend the money. Not only does this oversight keep the child from spending the money on something other than college, but it also allows the account owner to transfer the money to another beneficiary (e.g., a family member of the original beneficiary) for any reason. For example, say the original child for whom the account was set up chooses not to go to college—or doesn’t use all the money in the account—the account owner can then transfer the unused money to another named beneficiary.
If your child receives a scholarship, you have the ability to withdraw 529 plan funds up to the amount of the scholarship without paying the 10% penalty (you would still pay tax on the earnings from investments in this case).
Each 529 college savings plan offers its own range of investment options, which might include age-based strategies; conservative, moderate, and aggressive portfolios; or even a mix of funds from which you can build your own portfolio. Typically, plans allow you to change your investment options twice each calendar year or if you change beneficiaries.
Think carefully about how you invest your savings. A strategy that’s too aggressive for your time frame could put you at risk for losses that you might not have time to recoup before you need to pay for college. Being too conservative can also be a risk because your money might not grow enough to meet costs.
Potential tax benefits
Whether your contributions to a 529 plan are tax-deductible varies by state. If your 529 is used to pay for qualified higher education expenses, no federal income taxes are owed on the distributions, including the earnings. This alone is a significant benefit, but there are other tax benefits as well.
A 529 college savings plan may offer added estate planning benefits. Contributions are considered “completed gifts” when it comes to calculating estate tax, which means they are deducted from your taxable estate (but you still retain control of the account).
Gifts to an individual above $16,000 a year typically require a form to be completed for the IRS, and any amount in excess of $16,000 in a year must be counted toward the individual’s lifetime gift-tax exclusion limits (the federal lifetime limit is $12,000,000 per individual). With a 529 plan, you could give $80,000 per beneficiary in a single year and treat it as if you were giving that lump sum over a five-year period. This approach can help an investor potentially make very large 529 plan contributions without eating into their lifetime gift-tax exclusion. Of course, you could make additional contributions to the plan during those same five years, but these contributions would count against your lifetime gift-tax exclusion limit. Consider talking with a tax advisor if you plan to make contributions exceeding $16,000 a year.
We believe that retirement saving should always be the top savings priority. While you can borrow money to pay for higher education, there is no financial aid in retirement. That said, if your retirement saving is on track and education saving is among your financial goals, choosing to invest in a 529 college savings plan may be one of the best decisions you can make to help pay for qualified college costs. If you’re not sure how to make college saving a priority while continuing to prepare for retirement, please reach out to us to schedule a financial planning meeting with one of our professionals.
For other options for college savings, read our Guide to College Savings Plans.
As always, please reach out to us with any questions you might have.