529 College Savings Plans Are Worth a Close Look

Q. It’s time for us to begin saving for our child’s education. We’ve heard a great deal about Section 529 college savings plans. What are the advantages?

A. The advantages can be significant. Sec. 529 plans include both prepaid tuition programs and college savings plans. Because you mentioned the latter specifically, let’s focus on those.

Basically, a college savings plan allows you to place money in a state plan to be used for the beneficiary’s higher-education expenses at any college or university. These expenses include tuition, fees, books, supplies, and certain room-and-board costs. There’s no tax deduction for contributions made to the plan, but the money is allowed to grow tax-free until the funds are withdrawn to pay for qualified education expenses. Your money is invested in stocks, bonds, or mutual fund options offered by the plan, with no guarantee as to how much will be available when the beneficiary enters college.

Here are some of the more significant benefits of these plans:

  • You own the account and can change the beneficiary or even take the money back, if permitted by the plan. This is helpful in the event that your original beneficiary decides not to go to college. If you take the money back, you’ll owe income taxes on the earnings and a 10% federal tax penalty as well. The money can be withdrawn without penalty if the beneficiary dies or becomes disabled.
  • In 2024, you or other family members can contribute up to $90,000 to a qualified plan in one year and count it as your annual $18,000 tax-free gift for five years. If the gift is split with your spouse, you can contribute up to $180,000, also for five years. However, if you die within the five-year period, a pro-rata share of the $90,000 returns to your estate. Grandparents can set up accounts for grandchildren, transferring large sums from their estates while providing for their grandchildren’s education. (In 2023 the gift amount was $17,000 per year per recipient, $34,000 if the gift was split with a spouse.)
  • There are no income limitations for contributions. Thus, these plans may be of particular interest to higher-income individuals who may not qualify for other college savings tax breaks.
  • The assets in the plan are considered the account owner’s assets, not the beneficiary’s assets. For financial aid purposes, 5.6% of the parents’ assets and 35% of the child’s assets are to be used for college costs. If the grandparents are the owners, the assets may not even be considered for financial aid purposes. Although distributions are income tax free, their status for financial aid purposes is unclear. It may come down to a college-by-college decision whether the income will be considered the child’s income.
  • You can now make tax-free transfers of funds from one plan to another or from one investment option to another for the same beneficiary once every 12 months. In the past, the beneficiary had to be changed to make a tax-free transfer.

Private colleges and universities can now set up their own prepaid Sec. 529 plans. Distributions from these plans are eligible for the same federal income tax advantages as distributions from state-operated plans.

Most states now offer college savings plans, with the plans administered by the state or financial institutions. Certain state programs accept only residents, but most plans allow participants from any state. Before contributing to a plan, consider these tips:

  • Check out your own state’s plan first. Many states offer state income tax benefits to residents who contribute to their in-state plans.
  • Review investment options carefully. You can’t actively control the investments in your account, so you have to select from the plan’s options. Some offer a couple of choices, while others feature a more diverse selection. Recently, several plans added a principal-protected or guaranteed-return option to counter concerns about stock market volatility.
  • Examine fees. The management fees charged by plans vary widely and can significantly impact the performance of your fund. Some also charge an enrollment fee, an annual maintenance fee, and other annual expenses.College savings plans offered by each state differ significantly in features and benefits. The optimal choice depends on your objectives and circumstances. In comparing plans, consider each in terms of investment options, fees, and state tax implications.

Finally, bear in mind that the Tax Cuts and Jobs Act (TCJA) made it possible to use Sec. 529 accounts to pay for tuition at not only universities and colleges, but also public, private and religious elementary or secondary schools. The TCJA also allows you to take tax-free distributions of up to $10,000 per year to pay for these education costs.