What Is A 529 Plan?

A 529 plan is an investment vehicle for K-12 and college that receives preferential tax and federal financial aid treatment. They are sponsored by either a state or educational institution and often referred to as “Qualified Tuition Programs” in the tax code. Think of 529s as the college equivalent of a 401(k) or Roth IRA, only for education instead of retirement. You deposit after-tax dollars and, when you withdraw for qualified education expenses, receive tax-free distributions.

Most 529 plans have low minimums and are relatively easy to open yourself online. You could also speak with a financial professional who can assist you. Minimum requirements to open an account are a permanent U.S. address and tax ID.

Which 529 Plan Is Right For You?

There are two kinds of 529 plans:

• 529 “savings” plans are state-sponsored investments. Participants can select from the respective plan’s portfolios, typically some mix of mutual funds, ETFs, and bank products organized by target-date, target-risk, or individual portfolios.
• Prepaid 529 plans provide a guaranteed return indexed to an inflation metric, like in-state college tuition costs. Each “Prepaid” is structured a little differently, but the idea is to lock in today’s price for the future. Prepaid plans tend to be more restrictive than their savings counterparts. However, tuition costs rising between 6% and 8% annually over the past 50 years makes these worth consideration as part of a wider college funding strategy.

You do not have to use your home state plan, but there may be incentives to do so, such as tax credits, deductions, and matching grant programs. Note that some states restrict their plans to state residents exclusively. For example, as a resident of Massachusetts you could still invest in the 529 savings plans from New York or Nevada, but not in the Louisiana START 529 Savings plan or the Pennsylvania Guaranteed Savings Plan.

Use caution around wording, because nomenclature is not standardized. The aforementioned Pennsylvania plan uses “savings” in its moniker, but is actually a Prepaid plan. Be sure to do your research to understand what you’re getting before you open an account, or speak with a professional for guidance.

Is A 529 My Best Option?

If you’re saving for college a 529 is always worth consideration, but that doesn’t mean it’s going to be your best option. If you are in a lower income-tax bracket, have a shorter time horizon, or live in a state without an in-state tax benefit, you may be better off saving or investing in another vehicle, such as a Coverdell Education Savings Account or a taxable account like a brokerage or bank account. Everyone has a unique financial situation that requires careful consideration before investing.

Does A 529 Plan Affect Financial Aid?

Assets in a 529 plan will affect financial aid eligibility, but currently receive preferential treatment relative to most other savings vehicles. 529 plans are assessed at a rate of 5.64% of the account total if owned by parent or dependent student. So if there is $1,000 in said 529 plan the family would be expected to contribute an additional $56.40 towards college costs. This is compared to 20% for student-owned assets in most other accounts.

Financial aid is changing as a result of the Consolidated Appropriations Act signed in December 2020, but the changes will have limited impact on how 529 plans are treated. The “Expected Family Contribution” is being relabeled the “Student Aid Index.” At the moment, the formula itself does not appear to be changing significantly relative to 529 plans. Guidance is likely to be provided by the U.S. Department of Education and the IRS at some point. The changes take effect for the 2023-24 school year, meaning filers will be impacted starting with the October 1, 2022 financial aid filing date.

Financial aid is a complex topic and this does not cover the full scope of how 529 plans and other savings vehicles affect aid. You can find more information from studentaid.gov.

What’s “Qualified?”

There are two things you need to worry about to get tax-free distributions from your 529 account: qualified expenses and qualified institutions.

Qualified expenses include tuition, fees, books, supplies, room, board, computers & related equipment. You can also use up to $10,000 to pay for student loans, though there are some qualifiers to doing so (consider speaking with a tax professional if you are using a 529 to repay student loans). You can also use 529 plans to pay for up to $10,000 annually towards K – 12 tuition expenses, and only tuition expenses. Travel, computers, fees, etc. are not eligible K – 12 expenses.

Most college expenses, however, will qualify. That said, be wary that travel costs, sports & activity fees, and insurance do not. If you are concerned about whether a unique expense will qualify, consult IRS Publication 970, which is actually pretty readable if you know for what you are looking.

Qualified institutions include any school participating in the Title IV federal student aid programs. This is over 5,900 domestic and 400 international schools. You can look up schools from the Federal Student Aid Office.

What If My Child Does Not Attend College? Or Gets A Scholarship?

529 savings plans do not have an expiration date. You can continue to save inside the plan for another child or future grandchildren. If you decide to make a non-qualified withdrawal you will pay tax and a 10% penalty tax on earnings. However, there are exceptions in the event your child gets a scholarship, attends certain military schools, or passes away. In these cases you do not have to pay the penalty tax on non-qualified distributions. If you believe you qualify for an exception it is best to consult a tax professional.

Where To Start

Start with your home state plan. Over 30 plans have some form of tax incentive for using the in-state plan, be it a state tax credit, deduction, scholarships, or other benefit.

While you should always look at your home state first, you can invest in outside plans from other states and institutions. You may prefer an out-of-state plan if it offers lower fees or better investment options than your in-state plan. You can compare options using free online comparison tools such as collegesavings.org, which is run by NAST (National Association of State Treasurers). If it feels overwhelming, consider speaking with a financial professional.

This is a brief overview but, in actuality, 529 plans have a lot more benefits than are listed here, and can be complicated depending on your financial situation. For more details information refer to IRS Publication 970.

Brian M. Boswell, CFP® is a registered representative of and offers securities through MML Investors Services, LLC. Member SIPC. www.sipc.org, 101 Federal St, Suite 800, Boston, MA 02110. Tel: 617-439-4389. CRN202301-276762.