Use a 529 Plan to Save for College (and Save Thousands of Dollars)

Talking with a friend who has four kids, I suggested he look into using 529 plans for their college savings. I’m not sure if he ended up following the advice, but my guesstimate is that it would have saved him tens of thousands of dollars over more than a decade.

What Are 529 Plans?

These plans, named after Section 529 that was added in 1986 to the Internal Revenue Code (the federal tax code), are tax-advantaged savings and investment plans for education and education-related expenses. While this used to be limited to college education, as of the 2018 tax year they can also be used for K-12 education.

These plans are offered by states and educational institutions. States can offer savings plans and/or prepaid-tuition plans where you can “buy” future tuition at current prices. Educational institutions can only offer the prepaid-tuition flavor of 529 plans.

There are thousands of US colleges and universities for which you can use 529 plans, and hundreds of foreign educational institutions. You can check if a specific school is eligible through SavingForCollege.com.

Your options as to which plan to use are not limited by your state of residence or the school’s location. Thus, if you live in state A and your kid is planning to go to a school in state B, you can use a plan offered by state C if that plan seems best to you. SavingsForCollege also lets you research state 529 plans and compare them.

Some states, such as Maryland, even offer matching contributions, subject to income limits and first-come first-served funding limits.

What Can You Use 529 Plans for, and How?

The IRS considers these types of expenses as qualified for 529 plans:

• Tuition and fees
• Books, supplies, and equipment required for enrollment or attendance
• Expenses for special needs services required for enrollment or attendance (for special needs beneficiaries)
• Room and board (for students enrolled at least half time) up to the higher of the allowance for room and board determined by the school, that was included in the cost of attendance for federal financial aid purposes, given the specific living arrangement chosen by the student; and the actual amount charged by the school if the student resides in housing owned or operated by the school
• Computer hardware, software, and Internet access if used primarily by the beneficiary during his or her enrollment (excludes software for sports, games, or hobbies unless it’s predominantly educational)
• Apprenticeship-program-related expenses for fees, books, supplies, and equipment needed for the beneficiary to participate in the program (for distributions made after 2018)
• Up to $10,000 paid as principal or interest on qualified student loans of the beneficiary or beneficiary’s sibling

If you use 529 money for non-qualified expenses, you will typically need to pay income taxes and a 10% penalty on the portion of the money coming from earnings (that were thus never taxed before). There are certain situations in which you will not need to pay the 10% penalty. These include cases where the beneficiary gets a tax-free scholarship, attends a US military academy, dies, or becomes disabled.

While the above cases let you avoid the 10% penalty, you’d still need to report the earnings portion of the money taken from the 529 plan for purposes other than qualified education-related expenses. To avoid even that tax implication, you can do one of the following.

• Use the 529 funds for the beneficiary’s possible future educational use, whether another undergraduate program or grad school; or to pay off student loans
• Change beneficiary to a different family member (including yourself) and use the 529 funds for qualified education-related expenses for the new beneficiary; these can include up to $10,000 for K-12 expenses or to pay off student loans
• Roll the money over into a 529 ABLE account, intended for the disabled

To use money in a 529 plan you can distribute it to the plan owner (usually the parent), the beneficiary, or directly to the school. The exact details of how you can distribute the money may vary from plan to plan.

What Are the Tax Benefits of 529 Plans?

For federal tax purposes, 529 plans are treated similar to Roth IRAs. Contributions are made with after-tax money, but earnings grow tax-free as long as the funds are used for qualified education-related purposes. Contributions aren’t subject to gift taxes if they remain within gift-tax limits ($15,000 for a single contributor per beneficiary as of this writing), and interestingly, you can average those contributions over five years for gift tax exclusion purposes.

Contributions are not limited by income or age. Lifetime contributions vary between plans, but are very generous (think hundreds of thousands of dollars).

For state tax purposes, there is a difference between states. If your state offers a 529 plan, you can choose to use that plan or one from another body. In most states, if you use the state’s plan you may get a tax deduction for contributions made to the plan (e.g., Maryland allows up to $2500 to be deducted per contributor per beneficiary per year, and you can deduct contributions beyond that limit in future years up to a decade after the contribution was made).

Example of Tax Savings

Say you live in Maryland and will have four kids, two years apart starting this year. You plan for each of your kids to attend a 529-eligible school where the qualified expenses will be $50,000 per school year, so you start saving in a 529 plan for each kid from when they’re born. For this example, we’ll also assume that (hopefully) each of them will graduate after four years.

With an assumed 5% annual investment return, here’s what your hypothetical savings balances and tax deductions would look like.

Here’s what you should notice:

• You get about $400 in state and local tax benefits per child per year (Maryland state and local taxes are ~8% and you and your spouse can jointly deduct up to $5000/year per beneficiary).
• You can carry over up to 10 years any contributions that were above the deductibility limit in prior years. In this example, the large final contribution in 2048 is deducted starting in 2048 and until 2056.
• Your investment returns allow you to cover the assumed $800,000 total costs with less than $499,000 contributed over the years.
• Your annual contributions aren’t capped, and your lifetime contribution limit per beneficiary is high enough that you don’t hit it.
• You end up with a total of nearly $40,000 in reduced state and local taxes.
• You also end up not having to pay any federal, state, or local income taxes on the earnings in your 529 plans (just over $300,000 in this case). If your marginal combined tax rate is 30%, this translates to over $90,000 of additional tax savings. This is especially important these days, where you can’t deduct more than $10,000 on your federal tax return for your property tax plus your state and local taxes.
• As a caveat, note that having a lot of money in college savings may affect your eligibility for need-based scholarships. However, isn’t it better to have the money and not need those scholarships rather than risk needing them and not getting them for some other reason?

However, what if you only have one kid, and you didn’t have enough money to save anything for her college education?

Are you out of luck?

You’re not. You can open a 529 plan when she enrolls in college and simply put the money you’ll anyway spend on her education into her new 529 plan and then distribute it that same year to cover the educational expenses.

Here, your benefits are less impressive. There are no earnings in the 529 plan, so you have no tax savings on untaxed earnings. However, you get to deduct up to $5000 a year from your Maryland state and local taxes, carrying over any contribution overages up to 10 years. As a result, you save $5600 simply by passing through a 529 plan the expenses you’d have anyway.

The Bottom Line

The 529 plan is a great way to save for your kids’ college education, providing tax-free earnings on investments (assuming you spend the money on qualifying education-related expenses). If your state tax code provides for it, as does Maryland’s, you may also be able to deduct 529 contributions (subject to state-dependent limits and rules) from your state and local taxes, potentially many years past your kids’ graduation.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.