529 Savings Accounts and Why the Best Time to Open One Is Today
Saving for college is one of those things that has a bigger payoff the sooner you start, so if you’re a parent or family member searching for an efficient way to help your future college student pay their education costs, starting a 529 account should be on your list of options to explore.
What is a 529 savings account?
A 529 savings account is a college savings plan that comes with a variety of tax and financial aid benefits. These plans differ by state, and almost every state offers at least one 529 plan. There’s also a 529 plan operated by a group of private colleges and universities.
As of 2019, 529 plans can be applied to:
- Computers used for education
- Up to $10,000 annually in K-12 tuition
- Student loan payments
- Costs of apprenticeship programs
Any US resident can open a 529 plan, and anyone with a social security number or tax ID number can be named a beneficiary. The beneficiary can even be the person who sets up the account. The account owner keeps control of the money and can make investment decisions—they can also change the beneficiary, if needed.
What’s the benefit of using a 529 savings account?
The main benefit of using a 529 plan is that earnings accumulate on a tax-deferred basis, and withdrawals or distributions are not federally taxed when used for qualified higher education expenses.
Qualified higher education expenses include:
- Tuition and fees
- Room and board for students enrolled on at least a half-time basis
- Computer equipment and other necessary supplies
- Necessary supplies for special needs students
Keep in mind that if you withdraw money from your 529 account and use it for something other than qualified education expenses, taxes and a 10% penalty will apply.
Which states offer 529 plans?
Most states offer at least one 529 plan, and you can invest in any of them—not just your state’s—and you can apply your 529 plan to any qualified college nationwide. That means you could live in North Carolina, open a 529 account in California and go to a qualified college in Florida. More than 6,000 US colleges and universities and 400 foreign colleges and universities are qualified, so you have a lot of options to choose from.
Over 30 states and the District of Columbia offer state income tax deductions and tax credits for contributions to the state’s 529 plan, though you could be limited to investing in only your home state’s plan to get the benefit, so doing your research is imperative. Because you have so many options available, it’s a good idea to research 529 accounts by state and compare them to find the plan that will be of the most benefit to you.
What are the two types of 529 plans?
529 plans can be broken down into either college savings plans or prepaid tuition plans.
College savings plans act like Roth accounts in that they are affected by how well the investment options perform.
Prepaid tuition plans allow you to prepay all or part of in-state public college tuition. These plans can also be used at private and out-of-state colleges; however, the private college 529 plan is a separate prepaid plan sponsored by more than 250 private colleges.
What happens if the money in the 529 plan isn’t used?
If your child doesn’t use the 529 plan, you will generally have to pay income tax and a penalty on the earnings portion of a non-qualified withdrawal; however, there are exceptions if:
- The beneficiary received a tax-free scholarship
- The beneficiary attended a U.S. Military Academy
- The beneficiary died or became disabled
However, those earnings will still be subject to federal income tax and, in some cases, state income tax. If you want to avoid paying any taxes and penalties, you have the following options:
- Make another qualifying family member the beneficiary
- Keep the funds in the account in case the beneficiary chooses to attend another higher education institution later on
- Further your own education by making yourself the beneficiary
- Move the funds to a 529 ABLE account (an account for people living with disabilities)
- Make up to $10,000 in tax-free withdrawals for K-12 tuition
If you aren’t eligible for an exception and none of the options above work for you, you can still withdraw leftover money for any reason—just remember that the earnings portion will be taxed and incur a penalty.
Keep This in Mind Before You Open a 529 Savings Account
The sooner you open a 529 account and start contributing, the more time your money has to grow and the greater the benefit. If you start saving too late, you’ll have to make larger contributions to meet your target savings goal, and your money will have less time to recover from any economic ups and downs that occur during your savings period.
As with most things, the best time to get started was years ago. But the next best time is today.