MoneyLife

Understanding the Basics of 529 Plans

By Jacinta Sherris
529 plans

A 529 plan is a type of tax-advantaged investment account designed to encourage saving for a child’s future higher education expenses. The cost of college has increased by about 25% since 2009 – and isn’t becoming cheaper anytime soon. With student debt levels at all-time-highs, many parents are looking towards children’s education plans and 529 plans to help them ease the financial burden. 

529 plans were introduced in 1996 to help taxpayers prepare to pay college expenses for a designated beneficiary. Earnings in these plans are exempt from federal taxes, and each plan is sponsored by a state, state agency, or educational institution. Note that you aren’t restricted to using your own state’s 529 plan. A 529 plan is essentially an investment plan, much like a 401(k) or an IRA.

In this guide, we’re going over everything you need to know about 529 plans including the benefits of 529 plans and how do 529 plans work.

How do 529 plans work?

529 plans are a type of college savings plan. They feature an account owner, or someone in control of the investments, and a beneficiary. Most account owners are parents, guardians, or relatives of the child. The beneficiary is the child for whom the child’s education plan is intended. In some cases, the account owner and beneficiary may be the same person. 

529 plans work similarly to Roth 401(k) or Roth IRA accounts. The account owner deposits after-tax contributions into different investment vehicles, such as mutual funds, ETFs, and other investments. Investments grow on a tax-deferred basis and can be withdrawn tax-free if the money is used to pay for qualifying higher education expenses. 

Keep in mind that contributions towards 529 plans are not deductible from federal income taxes, however, some states may offer their own tax benefits for 529 contributions. 

What are the benefits of a 529 plan?

Contributions to 529 plans are made with after-tax dollars. However, all investment gains and qualifying withdrawals (distributions) are tax-free. In other words, you or your child won’t have to pay capital gains taxes on the money from the 529 plan as long as it’s put towards college expenses. 

Ideally, you’ll want to start contributing to your 529 plan as soon as possible, since this will give you more time to take advantage of compound growth and greater returns. 

Another big appeal is that you can transfer a 529 plan to another qualifying beneficiary without tax penalties. So, for example, if your intended beneficiary graduates from high school and decides not to go to college, you can designate another child or relative or even yourself as the new beneficiary (the money must still be used for qualifying education expenses).

Also, unlike some other types of investment/savings accounts, a 529 plan does not affect your child’s qualification for federal financial aid because they’re not considered to be assets of the minor.

There are two types of 529 plans: Prepaid Tuition Plans and Education Savings Plans. Savers tend to prefer the flexibility of Education Savings Plans vs. Prepaid Tuition Plans. Read more to see what might work best for you.

Disadvantage of 529 college savings plans

529 plans are solid options for saving for college, but they’re not without a couple of flaws. 

For starters, the funds within a 529 plan can only be used for qualifying expenses. If you use them for anything you’re not supposed to, you could face fines. 

529 plans also give account owners, not the beneficiary, full autonomy of the money in the account. The account owner can easily change the beneficiary at any time, or in the worst-case scenario, they can take a non-qualified distribution and liquidate the plan.

If you’re a young adult thinking of having a guardian set up a 529 plan for your college savings, make sure it’s someone you trust. 

What can I use my 529 savings for?

You can use the funds from a 529 to pay tuition expenses for elementary, secondary, college, or vocational education. Recent tax reform in 2018 also broadened the categories for qualifying 529 expenses to include:

  • On and off-campus housing
  • Food and meal plans
  • Books and supplies
  • Computers, software programs, and internet services
  • Special needs equipment

Types of 529 Plans

There are two types of 529 plans: Prepaid Tuition Plans and Education Savings Plans. Savers tend to prefer the flexibility of Education Savings Plans vs. Prepaid Tuition Plans. Read more to see what might work best for you.

529 Prepaid Tuition Plans

Prepaid plans allow you to lock in today’s current tuition price for tuition credits that your beneficiary can use in the future at participating universities. This can make financial sense when you consider that the average price of a public college education has gone up 237% over the last 20 years, according to US News and World Report.

However, if your beneficiary decides not to attend a participating university, the prepaid 529 plan will have strict rules around how much your prepaid tuition credits are now worth and how you may recoup your investment. Many investors don’t like the inflexibility of 529 Prepaid Tuition Plans and prefer the more flexible 529 Education Savings Plan.

529 Education Savings Plans

529 Education Savings Plans allow for more flexibility, as beneficiaries can use their withdrawals to pay for qualified tuition, room, board, and supplies at any US college, university, or vocational academy. 529 Education Savings Plans can also be used to pay up to $10,000 per year for qualified tuition at elementary or secondary schools.

Investment options within the plan include mutual funds and exchange-traded funds (ETFs), and many financial institutions offer age-based portfolios that are similar to the target-date portfolios used in retirement accounts. With age-based portfolios, asset allocations start off more aggressively when the beneficiary is younger and then shift to a more conservative approach as the beneficiary reaches college age to help protect the funds in the account.

With most 529 Education Savings Plans, there are certain fees that apply. Consider both in-state tax deductions and annual plan fees when comparing costs. Some states may also provide tax benefits to investing in 529 plans, but you’ll need to double-check with your specific state’s rules for tax consequences.

Alternatives to 529 plans

529 plans can be a smart way to save for education expenses — savings grow tax-free and you may even get some state tax benefits for your contributions. Nonetheless, there are other options when it comes to saving and investing for your or your child’s future. 

It helps to diversify a 529 plan with a traditional investment account – take MoneyLion’s fully-managed investment portfolios as an example. While this account doesn’t come with the tax advantages of 529 plans, it’s also more flexible – allowing you to use your money for whatever you see fit. 

Funds in a MoneyLion investment account can be used for a down-payment on a house, to buy a car or whatever else! It’s a sound resource to help you or your child prepare for the adult world.

Another important type of savings account is a safety net account. It’s essentially an emergency fund that can help you pay for unexpected expenses or cover bills if your job is interrupted. Learn more about MoneyLion’s investment accounts and our safety net account to get a head start on the future of your family!

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