What is 529 Plan?
The term “529 plan” refers to the tax-advantaged savings plan that has been created with the objective of supporting higher education expenses of the children in the future. In most cases, state or federal agencies or educational institutions sponsor these 529 plans. Initially, these savings plans were limited to post-secondary education costs, which has been later expanded to cover K-12 education (2017) and apprenticeship programs (2019). Given the purpose these 529 plans serve, they are also known as “qualified tuition plans”.
Explanation of 529 Plan
The name of the savings plan comes from section 529 under the federal tax code. Although anyone can open a 529 account, they are usually started by the parents (on behalf of the child) or the grandparents (on behalf of the grandchild). The child or the grandchild is the ultimate beneficiary of the 529 plan. Some of the states offer tax deductions to the persons who fund these accounts.
How does 529 Plan Work?
An investor opens a 529 account and starts contributing to it as per available plans in the state. The 529 plan management team then comes into play as they start investing the funds in some safe securities so that it grows gradually. The management team is responsible for the selection of investment schemes under the 529 plan. Once the period of the beneficiary’s educational expenses is over, the investor is entitled to utilize the remaining money in the 529 account for any other purpose, which will be subject to tax along with a10% penalty.
Types of 529 Plan
There are two types. They are –
- Prepaid Tuition Plan
- Education Savings Plan
Prepaid Tuition Plan
In this type of savings plan, the investor can purchase units or credits in the prospective colleges and universities for covering the future tuition and other associated expenses at the current prices. However, it doesn’t cover expenses pertaining to room and boarding in colleges and universities. Also, these plans are not for the prepayment of tuition fees for elementary and secondary education. In most states, the prepaid tuition plans are government sponsored.
Education Savings Plan
In this type of savings plan, the investors can open an account to start saving for covering expenses pertaining to the beneficiary’s higher education in the future. Unlike prepaid tuition plan, this plan also covers room and boarding expenses. In some cases, the beneficiary can withdraw money from this savings plan for covering educational expenses in non-U.S. colleges and universities. All such savings plans are sponsored by the state governments.
529 Plan Contribution Limits
The 529 plans don’t have any limit for an annual contribution. However, there are limits defined for the aggregate contribution that varies from state to state. The maximum aggregate limit vary in the range of $235,000in Georgia to $529,000 for California. Basically, these aggregate limits represent what each government considers to be the expected cost of higher education in their respective states. As per federal law, the balance of the 529 account can’t exceed the beneficiary’s expected cost of education.
Rules of 529 Plan
The rules binding the implementation of the plans are as follows:
- The growth of the money in a 529 account is tax-free until the withdrawal starts.
- As per IRS, if the drawn amount is used for qualified higher education expenses, then these withdrawals are not taxed.
- The drawn money can be used to cover rental expenses for students who don’t live within the college campus. Please note that expenses borne prior to joining a college or university (such as application fees) are not covered under 529 plans.
- The maximum limit of tax-free withdrawal for a year can be derived by deducting the total amount used to generate Lifetime Learning Tax Credit (LLTC) or American Opportunity Tax Credit (AOTC) from the total amount of higher education expenses for the given year.
- In case of expenses for K-12 education, the annual limit for tax-free withdrawals fixed at to $10,000.
Uses of 529 Plan
The primary uses of 529 pan include the following:
- To cover qualified primary education expenses of the beneficiary that includes tuition fees limit of $10,000 per year. It further covers the beneficiary’s expenses for qualified higher education, which includes secondary and higher secondary education.
- The amount in a 529 account can be used for full payment of training fees after secondary education and some portion of the private tuition expenses.
Some of the major advantages are as follows:
- It provides financial assistance to the beneficiary for covering expenses pertaining to qualified education courses.
- It relaxes the pressure on the parents for child education in the future.
- It offers tax saving options under various sections during tax filing.
- The capital appreciation in a 529 plan is tax-free until the point of withdrawal.
Some of the major disadvantages of a 529 plan are as follows:
- The benefits of the 529 plan are limited to qualified education expenses only.
- The investors have to incur high penalties in case they need to withdraw their own money for some purpose other than the qualified education expenses.
- The investments in a 529 plan generate a very low return on investment.
- There is a limited number of investment schemes under the 529 plan.
- At times it results in illiquidity as the money parked in a 529 account can’t be used for any other purposes.
This is a guide to 529 Plan. Here we also discuss the introduction and how does 529 plan work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –