The ABCs of 529 Plans

August 25, 2021
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If you are saving for your children’s college expenses, you have likely heard of a 529 plan. This is a popular option that’s specifically designed for college savings. As with any investment program, there are pros and cons to 529 plans that you should understand before deciding if it is the right solution for you and your family.

Recent tax changes have made 529 plans even more appealing, especially because they now include K-12 expenses in addition to college savings. This gives users more flexibility and tax benefits when using this plan for all educational costs. These new rules just part of the story, though, so let’s look at all the ABCs of 529 plans.

What is a 529 Plan?

A 529 plan is similar to other tax-deferred investment accounts like Roth IRAs or HSAs. However, these plans offer tax breaks only when used exclusively for qualified education expenses such as tuition, books, fees, room and board, and other educational supplies.

One difference between a 529 plan and a retirement savings plan like a 401(k) is that contributions to a 529 plan are made after-tax. Some states, however, will allow you to deduct your contributions for state income tax purposes. Once inside the plan, the funds are able to accrue investment earnings tax-free. They can ultimately be withdrawn free of taxes when used for qualified education expenses. If used for any other purpose, the earnings are subject to a 10% penalty.

The Tax Cuts and Jobs Act extended these tax savings to include qualified K-12 education expenses. Account holders are able to withdraw up to $10,000 per year, per child, tax-free for K-12 expenses.

Types of 529 Plans

There are two primary types of 529 plans offered in most states:

  1. 529 Savings Plan—You can invest your contributions in a pre-selected set of mutual funds, similar to a 401(k). The funds can later be used for any qualified education expenses in any state.
  2. 529 Prepaid Tuition Plan—These plans allow you to pre-purchase college credits at public in-state universities. They are less flexible than 529 savings plans that can be used for out-of-state schools, but they offer more certainty by pre-purchasing credits at a specific school.

Pros of 529 Plans

As you might expect, the tax benefits are the biggest appeal of 529 college savings plans. You are able to earn money on your investment funds that can later be used tax-free for qualified education expenses. They offer high contribution limits, as well.

Though 529 plan contributions are not tax-deductible from a federal income tax standpoint, they are deductible for state income taxes in more than 30 states. 529 plans also offer flexibility to change beneficiaries at any point, so the funds aren’t pre-designated to one specific child or family member.

Cons of 529 Plans

Of course, the main downside of a 529 plan is that the funds must be used exclusively for qualified education expenses. If a child does not end up going to college and/or doesn’t spend the full savings amount, you will be subject to a 10% penalty if using the money for something else.

It’s also important to know that some states apply penalties for withdrawals used for K-12 expenses. The federal tax laws have changed, but not all state tax laws have been updated in the same manner. Be sure and research your state tax laws regarding all 529 contributions and withdrawals.

529 also offer a limited set of investment options, so you have less flexibility with how your funds are invested over the life of the plan. Some of these investment portfolios can be expensive, as well, so you have to make sure the plan is worth your investment.

529 plans are great for some families who want to have a separate, simplified and tax-advantaged savings plan for college and covering some K-12 expenses. However, they are not for everyone. Because the money is designated only for qualified education expenses and the plans have some investment limitations, they may not offer as many benefits as Roth IRAs or other long-term investment accounts. You may be able to set up a different savings plan or investment strategy that provides you with more money and additional flexibility when the time comes to send your kids to college. Meanwhile, you can be saving for your own retirement without diverting all your funds into a college savings account.

To learn more about 529 plans and other savings strategies for education, healthcare and retirement, contact Illumination Wealth today. Our advisors will help you make the right decisions for your family’s future and create the ideal financial plan tailored to your short-term needs and long-term goals.