Advantages & Disadvantages of 529 Savings Plans
529 savings plans are a well-known and popular tool to help families plan and save for higher education expenses, but what exactly are they, and how do they work? Formally known as qualified tuition programs as defined under Internal Revenue Code Section 529, a 529 savings plan is generally a tax-advantaged plan designed to help families save and pay for education from kindergarten through graduate school, though it is commonly used for college/graduate school.
While there are many advantages generally associated with 529 savings plans, they provide two significant federal income tax advantages: tax-deferred growth and tax-free withdrawals if used for qualified education expenses. It’s important to note that while state income tax rules generally follow the favorable federal tax treatment, there are some states that tax residents on earnings from out-of-state plans, so it’s best to check with your specific plan.
Qualified higher education expenses include the following:
- Tuition, fees, books, supplies, and equipment required for a designated beneficiary’s enrollment or attendance at an eligible educational institution
- For an eligible student (enrolled at least half-time) for any academic period, the reasonable costs for that period incurred by the designated beneficiary for room and board while attending the institution
- For a special needs beneficiary, expenses for special needs services that are incurred in connection with the beneficiary’s enrollment or attendance at the institution
- Expenses for the purchase of computer or peripheral equipment, computer software, or internet access or related services if the equipment, software, or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution
- Expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school; the amount of cash distributions from all qualified plans with respect to a beneficiary during any tax year can’t, in aggregate, include more than $10,000
- Fees, books, supplies, and equipment required for a designated beneficiary’s participation in an apprenticeship program that is registered and certified with the Secretary of Labor under Section 1 of the National Apprenticeship Act
- Amounts paid as principal or interest on a qualified education loan of the designated beneficiary or a sibling of the designated beneficiary
Additional advantages of a 529 savings plan include:
- Low maintenance – The accounts can be opened online or through a licensed financial advisor. You also can select an automatic investment plan so you don’t have to remember to contribute to the plan or reallocate the investments
- Favorable financial aid treatment – When a dependent student’s parent or a dependent student owns a 529 savings plan, it’s reported as a parental asset and has a relatively minimal effect on financial aid eligibility. Distributions from parent- and student-owned accounts aren’t counted as income on the Free Application for Federal Student Aid
- Owner control – The 529 savings plan account owner has legal control of the account funds and can distribute the money as needed to ensure the beneficiary isn’t using the funds for nonqualified expenses
Some notable disadvantages of a 529 savings plan include:
- State income tax recapture – If a plan account owner does a rollover into another state’s plan, any state income tax deductions and credits previously claimed may be subject to recapture, and the earnings portion of the outbound rollover may be added back to state taxable income
- Limited investment choices – The plan owner must select investments from a menu of investment options offered by the 529 plan. This typically includes static investment portfolios that aim to achieve a targeted level of risk, individual fund portfolios, and age-based portfolios that automatically shift asset allocation as the beneficiary gets closer to college
- Fees – The more families pay into the 529 savings plan fees, the less they can save for college. The fees vary among 529 savings plan portfolios
- Ownership rules – The 529 savings plan account owner, not the beneficiary, has legal control of the money in the account. This means they can easily change the beneficiary at any time or take a nonqualified distribution and liquidate the plan. This might become an issue if a parent is depending on a grandparent’s or other relative’s 529 savings plan to pay for their child’s college education
The most common concerns we hear regarding use of 529 savings plans are overfunding the account or the child later deciding not to attend college. There are a few strategies that can be used to help combat these concerns. Let’s first look at contribution limits for the accounts. While there are no yearly contribution limits, some states do put a cap on how much you can contribute throughout the life of the account. This can range from $235,000–$529,000, so it’s best to check with your state for the specific amount. The assets within the account can grow beyond those limits, but total contributions may not exceed them. Contributions also are made with after-tax money and therefore aren’t tax deductible.
If the accounts are overfunded, the beneficiary doesn’t attend college, or a distribution wasn’t qualified, you can pull the funds with a 10 percent penalty tax and distributions are includible in gross income. However, there are a few notable exceptions to this rule. You can withdraw funds penalty-free to the extent the beneficiary’s expenses were reduced due to education tax credits, amount of scholarships, veteran’s education benefits, or other tax-free payments of expenses. You also may withdraw funds penalty-free if the beneficiary goes into the military, becomes disabled, or passes away. In addition, 529 savings plans can generally be used at vocational or other post-secondary institutions in the U.S. as well as many foreign institutions.
While a 529 savings plan can stay active for the life of the beneficiary, you may find that the beneficiary will never use the funds that have accumulated within the account, but you don’t want to pull the funds and pay taxes and/or a penalty fee. A simple way to avoid those consequences is to transfer the 529 savings plan into another beneficiary’s name. If the new beneficiary is a family member of the account owner, there will be no tax implications.
As with any of these planning techniques, please consult your trusted tax and financial planning professional to see how it affects your specific situation. For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.