For most people, the choice of college savings vehicle is easy: 529 plans provide tax-free investment growth and withdrawals for qualified education expenses. Parents who start saving in a 529 account when their children are young can take advantage of that tax savings, as well as compound interest and — in some states — a tax deduction on contributions.
Because of those tax advantages, 529 plans do have a few rules, including guidelines around what qualifies as an education expense. Here’s what you need to know about these plans.
529 plans are state-sponsored
Each state offers at least one 529 plan. You don’t have to invest in your own state’s plan; though many states offer residents a state tax deduction for doing so, there is no federal tax deduction for 529 contributions. If your state doesn’t offer any tax benefits (check our list of all state plans), shop around to find the best plan for you: NerdWallet’s 529 tool can help you narrow down your options. The state that sponsors your plan also doesn’t have any role in where your child can go to school; students can use the money to attend a qualified school in any state.
The exception here is a specific kind of 529 plan called a prepaid plan, which, as the name implies, allows you to prepay tuition at an in-state, public college, locking in the cost in today’s dollars and at current tuition rates. These plans make sense only if you’re sure your child will attend an in-state, public school. Only 12 states offer prepaid 529 plans.
The account holder maintains ownership of the funds
Unlike other college savings vehicles such as custodial accounts, 529 plans allow the funds to remain under the account owner’s control, meaning you can withdraw the funds at any time (though taxes and penalties may apply; more on this below). The beneficiary does not have control over the funds in the account.
There aren’t set contribution limits
The IRS says “contributions cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary.” So, unlike other tax-advantaged accounts — such as Roth and traditional IRAs — 529 plans do not have specific contribution limits set forth by the IRS. Most states do set limits of $300,000 or more.
However, contributions may trigger gift tax consequences if you earmark more than the gift tax exclusion ($14,000 for 2015) for any one beneficiary in a tax year. The vast majority of people do not need to worry about this; not only because they are unlikely to need to contribute that much per year to meet their savings goals, but also because of the unified credit. More on that here.
Qualified distribution rules are strict
529s are specifically for qualified higher education expenses, though that category extends beyond tuition; it also includes fees, room and board, textbooks, computers and “peripheral equipment” (like a printer). Withdrawals made for purposes outside the rules will hurt: Earnings withdrawn for non-qualified expenses are subject to a 10% penalty and ordinary income taxes. There is no penalty on the principal.
There are a few exceptions: If the beneficiary receives a scholarship, you can withdraw funds equal to the amount awarded; the earnings will still be subject to taxes but there will be no additional penalty. Parents are also free to change the beneficiary on the account at any time, so if, for example, your first child decides to take a different path, you can change the account beneficiary so that the funds will go toward paying for a younger sibling’s education instead.
The bottom line
For many families, 529 plans will be the obvious choice for college savings. Most plans offer age-based investment options that will automatically rebalance, taking more risk as your child is young and less as he or she approaches college age. You can open a 529 plan directly through your state’s plan website.
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