Planning to send your child to college? A 529 plan, also known as a qualified tuition plan, could offer you some worthwhile advantages.

If you’re planning ahead for your child’s education, you may be thinking about a 529 plan. Here are all the details you need to know about how to open a 529 plan, fund a plan, and receive the tax benefits these plans offer.

What Is a 529 Plan?

Anyone can open a 529 plan account, but typically these accounts are used by parents and grandparents who designate their children and grandchildren as the beneficiaries.

Named after Section 529 of the Internal Revenue Code, 529 plans are tax-advantaged savings accounts designed to encourage early saving for future education costs. They are administered at the state level, although they are authorized at the federal level and legally known as “qualified tuition plans.”

Anyone can open a 529 plan account as long as there is a living beneficiary, but the plan is typically used by parents and grandparents who designate their children and/or grandchildren as the beneficiaries. The funds from a 529 plan account can be used only for qualified education expenses. These tuition savings plans are sponsored by states, state agencies, or educational institutions.

529 Plan Types

Qualified tuition savings plans based on Section 529 of the federal tax law are divided into two main types:

1 Prepaid Tuition Plans

Offered in a limited number of states, 529 prepaid tuition plans allow you to pay tuition now and use it in the future, even if the price of tuition increases. These plans are a good hedge against inflation and the increasing costs of higher education.

Prepaid tuition plans are restricted to tuition at participating state colleges, universities, and higher education systems. Most plans require the student beneficiary or the plan owner to be a resident of the state offering the plan. These plans cannot be used to pay for room and board, books, or other related expenses. Prepaid 529 accounts are funded with after-tax money, which means contributions could qualify as a tax deduction. When the money is withdrawn, it is tax-free if it is used for a qualified purpose – paying tuition or up to $10,000 in student loans.

The cost of the plan depends upon the age and grade level of the student beneficiary at the time the plan is purchased. You can purchase a plan by paying a lump sum, in regular payments over a five-year period, or in fixed monthly payments.

2 Education Savings Plans

State-sponsored 529 education savings plans allow you to open an account where your money is invested in mutual funds, exchange-traded funds (ETFs), or money market funds. Most plans offer age-based investment allocation options that will automatically rebalance the portfolio over time, taking more risk as your child is young and less as they approach college age.

Timing is key to capitalizing on investment choices in these funds. If you expect to withdraw money sooner, like for elementary school tuition, you may want more conservative investment options than if you plan to grow the fund for the child’s first 18 years and then apply it to college.

A 529 education savings plan can be used at almost any college or university in the country and even some non-U.S. institutions that are part of the federal student aid program. Education savings plan funds may be used to pay for tuition and fees plus room and board, books, and other qualified expenses. The funds could also be used at a private, public, or religious schools for grades K-12. Only a few 529 education savings plans have residency requirements for the investor or the beneficiary.

529 Plan Advantages

Specifically for education savings, 529 plans have a couple advantages over any other type of savings and investment product.

1 Taxes

Because the government wants to incentivize saving for education, a 529 savings plan offers tax benefits. As your investment account grows, you do not pay federal taxes on its earnings. As long as the money is used for qualified education expenses, there is no tax charged on withdrawals, either.

By contributing to a 529 account, you may receive tax breaks in your state. If you choose a 529 plan in the same state where you pay income taxes, you may qualify for a tax deduction or credit on the after-tax money you invest in the account. Some states offer matching grants for 529 contributions for those who meet the residency requirement.

2 Financial Aid

Whether you own your 529 account or it is owned by your dependent child, the funds are not counted as your child’s assets on the Free Application for Federal Student Aid (FAFSA) form, but as parental assets. Who owns the 529 plan affects the impact on the student’s financial aid prospects. If the 529 plan is owned by the student or the student’s parent, it has a minimal impact on eligibility for need-based financial aid. However, if the 529 plan is owned by someone else, such as a grandparent, it will hurt financial aid eligibility.

529 Plan Contribution Limits

Most tax-advantaged investment accounts, like IRAs and 401(k)s, limit the amount of money you can invest each year. According to the IRS, these limits are set so that those who can afford to contribute more don’t get greater tax advantages than everyone else. When it comes to 529 education savings plans, the IRS has not set a specific dollar amount limit on contributions but advises that contribution amounts should be limited to the amount needed for the beneficiary’s intended education expenses.

Extremely high annual contributions to a 529 plan can trigger a gift tax filing if the amount exceeds the gift tax exclusion in a tax year. A parent or grandparent can make a lump sum contribution that is the equivalent of five years of contributions without requiring gift tax. Consult your tax advisor for current requirements. Most people will not need to make large contributions to their 529 account to meet their education savings goals and won’t have to worry about triggering a gift tax filing and having the contributions count against their lifetime gift tax exemption. Keep in mind that while a 529 account has tax and investment advantages, there are restrictions for withdrawing the money tax-free.

Using a 529 Plan Account

A 529 plan can be used only to pay for eligible expenses. Be sure to check with the sponsoring state or institution for clarification on what this includes. Education savings plans allow you to use funds to pay for tuition and fees, room and board, books and supplies, and equipment. Both on- and off-campus expenses may be included. Any funds from your 529 account used to pay for non-qualifying expenses will incur federal income tax and a 10% penalty.

A qualified 529 plan might be the right financial instrument for you. Like any other financial decisions, though, be sure to investigate all the details and options before proceeding. Consider contacting your financial institution with any questions you have about college savings accounts.

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