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529 Accounts: Everything You Need to Know

By Team Tomorrow
Published September 13, 2021

529 accounts can be a parent’s new best friend. 

A 529 plan is an investment account comparable to a Roth IRA or Roth 401(k) that offers tax benefits for qualified education expenses, including:

  • Tuition and fees
  • Room and board or rent
  • Computers, similar electronics, and internet access
  • Textbooks and other materials
  • Special needs equipment

Unlike a custodial account, the owner of the 529 account maintains possession of the account until the money is withdrawn. As long as the money remains in the account, you don’t have to pay income taxes on the earnings. When you take money out for education-related expenses, they are usually both state tax and federal income tax-free. That all depends on the type of plan you have and what the rules are in your state or district.

Each 529 plan offers investment portfolios customized to your risk tolerance and time frame. Much like the stock market, your portfolio may increase or decrease in value based on how your investment performs. Saving For College has a tool that helps you compare plans to determine what works best for you. 

The main types of 529 accounts fall into two categories: 529 savings plans and prepaid tuition plans.

529 Savings Plans

With savings plans, the account holder contributes money and can choose the funds they want to invest in. 529 savings plans also offer target-date funds, which means your assets can grow in a way that is optimized for an allotted time frame (i.e. when your child starts going to college). 

Prepaid Tuition Plans

Prepaid tuition plans allow you to lock in future tuition costs at current rates, which circumvents college inflation. These plans are usually meant for pre-paying all or part of the costs of an in-state public college education. However, they can also be used at private and out-of-state colleges with a Private College 529, a prepaid plan sponsored by more than 300 private colleges.

The downside with prepaid tuition plans are their limitations. Unlike savings plans, they usually only cover tuition and fees. Money.com suggests that unless you’re positive your kids will end up going to a State U school, a traditional 529 savings account is a safer bet. 

Do 529 Accounts Impact Financial Aid?

The assets in your 529 account are considered a parental asset on your FAFSA, but at a limited capacity. The first $10,000 saved isn’t counted as part of your Expected Family Contribution. For any amount after that, only a maximum of 5.64% is counted, compared to the 20% considered in other plans. 

Here’s what this looks like:

Expected Family Contribution (EFC): 529 Accounts vs. Other Plans
Amount Saved EFC for 529 Account EFC for Other Plans
$10,000 $0 $2,000
$20,000 $564 $4,000
$50,000 $2,256 $10,000
$100,000 $5,076 $20,000

 

*The higher your EFC is, the less financial aid you and your child can qualify for. 

If someone else owns the 529 account, like a grandparent, aunt, or wealthy friend, it won’t impact your FAFSA. However, it is counted as student income when they withdraw the funds to pay for your child’s education expenses. Student income is assessed at 50%. This means if a grandparent pays $10,000 of college costs, it reduces your child’s aid eligibility by $5,000. 

You can avoid this by withdrawing these funds during your child’s last two years of school. The FAFSA looks at income from two years prior:

  • If funds are withdrawn during their freshman year, it impacts aid eligibility for their junior year. 
  • If funds are withdrawn during their sophomore year, it impacts aid eligibility for their senior year. 
  • By waiting until your child’s junior year, it wouldn’t impact aid eligibility until after their expected graduation date. 

Other Benefits of a 529 Plan

  • They’re “hands-off” – All you have to do is select the plan that best fits your needs. Most of these plans allow you to make automatic investments linked to your payroll deduction plans or bank account.
  • You control it, but don’t have to manage it. The management of your investments is handled by a program manager, the state treasurer’s office, or another outside investment company.
  • Contributions don’t have to be reported – You won’t receive a 1099 until you begin making withdrawals.
  • You can contribute a lot – 529 accounts have high contribution limits, which are state-dependent. Deposits of up to $15,000 (or $30,000 if you’re married and filing jointly) qualify for the annual gift tax exclusion. Doing so can help reduce estate taxes.
  • Rollovers – You can rollover your contributions into another account once every 12 months. 

What Happens if Your Child Doesn’t Go to College?

Life happens. 

If your child doesn’t go to college, you will usually have to pay income tax and a penalty of the earnings portion when withdrawing funds, since it’s not for educational purposes. The penalty is waived when the following conditions:

  • The beneficiary becomes disabled or passes
  • Your child attends a US Military Academy
  • Your child gets a tax-free scholarship

Leftover Funds

If there’s money leftover in your 529 plan after your child completes their education, you have a few options:

  • Withdraw it and pay the taxes and penalties
  • Change the beneficiary to another family member, like your child’s younger sibling
  • Make yourself the beneficiary if you decide to return to school
  • Keep the funds in the account to pay for grad school
  • Use it for K-12 tuition or an apprenticeship program
  • Roll it into a 529 ABLE account, a savings account for people living with disabilities

Check out our guide to college financial planning to learn more and explore other options. 

One of the best alternative options is to get a permanent life insurance policy. Saving for college is only one of the benefits of getting a perm life policy.


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