If you have kids that aspire to attend college, one of the financial tools available to them is a Section 529 Plan. Section 529 Plans are sponsored by state agencies, states or educational institutions. A Section 529 Plan is named after a section in the Internal Revenue Code, which was authorized to allow for tax free status for “qualified tuition programs.” The earnings on a 529 plan accumulates on a tax-deferred basis. Distributions are not taxed federally when used on higher education expenses. As recently as 2019, higher education expenses were expanded to include computers, K-12 tuition (up to $10,000), student loan payments, and the cost of apprenticeship programs.
Types of Plans Available
There are two types of 529 Plan available. The first one is a prepaid tuition plan. This allows the account holder to purchase credits at an educational institution at the current year tuition rates for a future date. Only tuition is allowed to be purchased. Room and board are disallowed as part of the prepaid tuition plan. The limitation to using the prepaid tuition plan is that a student is limited to which universities will accept the plan.
The second plan is the education savings plan. This differs from the prepaid tuition plan because a person can open an investment account to pay for the beneficiary’s higher education cost, which include tuition, mandatory fees, and room and board. The account holder chooses mutual funds to invest. The mutual funds’ performance determines how the account will grow.
Tax Advantages
There are tax advantages to 529 plans. Earnings are exempt from federal and state taxes provided that the distributions are used for qualifying educational expenses. Any distributions that are not used for qualifying educational expenses are subject to a 10 percent penalty.
Contributions to 529 Plans are not tax deductible for federal income taxes. On the other hand, contributions are tax deductible in many states.
Growth in 529 Plans
It is important to note that the earlier that one invests into a Section 529 Plan, the longer it will be allowed to grow. If the 529 Plan is used to pay for K-12 tuition, then there will be less to invest for future growth.
Changing Beneficiaries
There are instances in which the account holder may change beneficiaries. One instance is when the beneficiary receives a scholarship. A second instance is when the beneficiary decides to attend a U.S. Military Academy. The third instance is when the beneficiary dies.
Fees
The fees associated with a 529 Plan are important to consider because they lower the amount that is in the account. Fees vary between the prepaid tuition plan and the education savings plan. Prepaid tuition plans may charge an enrollment/application fee and recurring administrative fees. Education savings plans may charge an enrollment/application fee, annual account maintenance fees, ongoing program management fees, and ongoing asset management fees.
Before one purchases a 529 Plan, it is best to consult with an investment professional to discuss what you want to achieve out of a 529 Plan.