529 deep dive
Updated: Mar 2
Truth be told, the 529 typically gets the least amount of interest in class. It tends to fall lower down the priority ladder as compared to the 401k, IRA, and HSA. And rightfully so, as it has a more limited function. But with that said, it’s still extremely powerful, so it deserves its own newsletter. Unlike the other investment accounts listed above, 529 plans are typically operated by states. Because of this, we can’t dive into each state’s plan and benefits in class. But let’s try to break this thing down as much as possible today.
The 529 Skinny
529s are tax-advantaged, state-sponsored accounts meant to help you prepare for higher education and related expenses
Earnings in a 529 largely grow tax-free as long as distributions are applied to qualified educational expenses
Additional 529 benefits vary state-to-state, with some offering state income tax deductions or credits
Plans may vary state-to-state as well, many with their own providers, rules, and regulations
If you like what you see, read on for more...
What is the 529 used for?
529s can be used on qualified expenses such as:
College and postgraduate tuition and fees*
College housing, food and meal plans, books and supplies, computer and computer software, internet services, and special needs equipment
Public, private, or religious elementary and secondary school fees (but only up to $10,000 per year per student)
Incurred student loan debt ($10,000 lifetime limit)**
Who is the 529 for?
Some people are confused whether or not to open a 529 for themselves or for their children. It’s largely designed as a tool for parents to help with their kids' education. Here is how the account works...
When you open a 529 plan you will be required to designate a beneficiary. While you are the official account owner, the beneficiary is the one who receives the money for qualified education expenses. Generally, any family member can be your 529 beneficiary, but most people tend to designate their children as such. Typically a parent will have one account per child. If you do not yet have children, you can open an account and make yourself the beneficiary and then change it later on once you do have children. (By the way, that is what both Joe and I have done as we do not yet have children).
What are the tax benefits of funding a 529?
Let’s talk about federal tax benefits first.
All 529s, regardless of which state, offer the following benefit: earnings grow tax-free and are free from federal income tax when used for qualified education expenses. This is true regardless of what state you live in and what 529 plan you invest in. Tax-free earnings are a huge benefit when preparing for future expenses! (Remember, our arrow, circle, arrow model for Tax Free Accounts).
Are there tax benefits at the state level?
In most cases, qualified 529 plan distributions are also exempt from state income tax, similar to the federal tax benefit outlined above***. Beyond that, certain states offer additional tax benefits like deductions and credits. Exact benefits vary quite a bit state-to-state. You don’t need to know each state’s rules, you just need to figure out yours. Generally speaking, most states fall into these tax groupings:
In-state tax benefit: These states offer a tax deduction or credit for contributions, but only if you contribute to that state’s unique 529 plan. Deduction or credit amounts vary by state-to-state.
Tax-parity: These states offer set tax deductions or credit, but to any 529 plan (including out-of-state plans)
Tax neutral: These states already don’t have an income tax or they do not offer any additional tax deductions or credits at the state level
Head here to explore which grouping your state falls into and its potential tax benefit.
Source: theeducationplan.com In addition, I found Vanguard's 529 plan comparison tool to be very detailed and informative for most states. I highly recommend checking this out for plan overviews top to bottom. How much can I contribute to a 529? A main benefit of the 529 plan is its extremely high contribution limit. Rather than specifying an annual contribution limit (like the 401k, IRA, and HSA), most states put a limit on total contributions made to a 529 (over time). For example, maximum contribution limits (per beneficiary) range from $235,000 to >$500,000 across states. Most people won’t hit this ceiling****. But, as I’m reminding you again and again, check your local state’s rules. Can I open a 529 with any bank? Not really. Providers are also offered at the state level. Sometimes states partner with more established providers (like the state of MA partners with Fidelity for its Ufund College Investing Plan, but Utah has its own unique provider my529). If you don't like your state's bank or plan, you can actually choose to invest in another state's 529 plan (as you might if you live in a tax parity state). BUT, most often, this is not always recommended as you may lose out on potential local state tax deductions or credits as mentioned above (as you do in a in-state tax benefit state). What do investment options look like? Can I invest in index funds? When you enroll in a 529 college savings plan, you’ll need to select an investment portfolio from one of the choices offered by your plan. Again, (I know I sound like a broken record here) your options vary state-by-state. Many plans offer age-based target fund options which rebalance allocations based on your child’s age. At the same time, many others offer individual fund options. Some states offer a wider selection of funds than others. But like your 401k, you’ll only be able to select investments based on the funds you have access to through your provider. While many states aim to keep costs low, the general truth here is that most state 529 plans have higher fees than Yield & Spread’s recommended 3-fund index portfolio. With that said, the tax benefits of 529s are so great that you should still happily consider investing. Just remember to seek out low-cost index fund options with the 529 offering and allocate based on your time frame to use those funds. What happens to my 529 plan if I don't use the funds? Ultimately if the money is not used for education expenses and you want to use it for something else, you will be subject to federal income tax and a 10% federal tax penalty, as well as state and local income taxes. With that said, as long as there is a living beneficiary on the 529, the account can live on. So for example, if your kids don’t go to college, you can pass it on to your grandkids. Or if you don’t have kids, you can pass it on to a niece, nephew, or other family member who might be in need.
Post updated March 3, 2023:
Starting in 2024, you'll be able to rollover funds from a 529 plan into your beneficiary's Roth IRA. In other words, if the beneficiary does not use all the 529 funds available to them, you can still support them by rolling those funds into their Roth IRA. The max you will be able to rollover per year is $6,500, with a lifetime limit of $35,000. And one more thing. The 529 plan itself must be at least 15 years old before you can do any rollover, and and contributions less than 5 years old are ineligible.
Some frequently asked questions about 529s... I’m not sure when (or if) I’ll have kids? Should I wait to invest in a 529? If you do not yet have kids or are still undecided, prioritize your 401k, IRA, and HSA. If you have extra money laying around to invest, and you’ve already maxed out your other tax-advantaged accounts for the year, consider contributing to your 529 if you can get any additional state income deductions or credits. This is a good strategy in that you get the tax benefit of the deduction and continued earnings that grow-tax free, while also preparing for the long-term. I’m thinking about going to grad school. Should I invest in a 529 for myself? Think about your timeline here. Investing in a 529 follows the same timeline guidelines I’ve suggested for any other investment account. If you plan to apply and attend school in the next 2-3 years, it’s risky to invest your money in case the market tanks. If you have a 10-year timeline, you have more time to avoid risk and for your investments to compound, but most people tend to not have this long of a timeframe when considering applying to grad school. Lastly, I thought you could use an IRA to pay for college? Good question, this is also true. Before 59 ½ years old you can use the contributions at any time to help pay for college without being taxed or facing a penalty (as dicussed in this blog post). After you hit 59 ½ (and it’s been 5 years since you first contributed to your Roth), both the contributions and now earnings can be used to pay for college tax-free. This timeline likely joins up with your children heading off to college. But just remember, while you can use this for your kids’ college, save enough for yourself for a healthy retirement...it's the biggest gift you could give your kids to not be a financial burden to them in your old age. A final note, your IRA contributions are limited to $6,000 a year for individuals, so therefore the 529 enables you to sock way more away for college with its liberal contribution limit threshold. .... Phew! That was a long one, but worth it. I hope most of your questions are answered here. There are still more variations to the 529, so if you have more detailed questions continue to peruse the many resources provided in this month's newsletter!
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*The institution must accept Federal Student Aid (FAFSA®) to qualify for a 529 distribution. You can see a full list of institutions here. It’s pretty exhaustive. Many vocational and trade schools are also on this list.
**Re: student loan debt...the primary purpose of a 529 is to invest in advance of higher education expenses, but if you find you have some funds leftover, you can apply them to another educational debt burden (say a siblings or another family member)
***There are some pretty unique exceptions to this, like taxation around non qualified dividends in certain states. Make sure to check your state’s 529 rules and regulations.
****If you are a high income earner who thinks they will be actively contributing large sums to their 529, you may want to read up on Gift Tax Considerations. As of 2021, you can contribute up to $15,000 per beneficiary ($30,000 for a married couple) without using up part of your lifetime gift tax exemption or having to pay gift taxes. You can read more here.
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