7 Powerful Benefits of 529 Plans

Content Type: Article

529 savings plans are a great way to save for college as they are flexible and provide many tax benefits.

With the cost of college rising year over year, it’s hard to imagine what tuition might be 15 to 20 years from now. However, one way to prepare for these future expenses is to utilize a 529 college savings plan. 529 savings plans are a great way to save for college as they are flexible and provide many tax benefits. Funds in 529 plans are not only used to pay for a wide range of college expenses, they may also be used to help cover primary and secondary education expenses for children in kindergarten through 12th grade. Further, certain apprenticeship costs and student loan repayments can be offset using 529 plan funds.

Another added benefit is that the owner of the 529 plan, often a parent or grandparent, maintains control of the account until money is withdrawn. And because the child does not have ownership of the account, those funds will not negatively impact their ability to qualify for federal student aid.

Each plan is sponsored by an individual state and typically managed by a financial services company. An individual may participate in any state’s 529 plan regardless of their own state of residence. However, it is advantageous to check with one’s own state plan to determine if there are any additional benefits offered to residents. It is also important to consider the various plans’ investment options and fees to find the plan that is best suited to the investment strategy and time horizon of the beneficiary to maximize potential savings and account growth.

Benefits of a 529 College Savings Plan:

Although there are many different types of investment vehicles available for college funding, 529 savings plans offer unique features unavailable to other plans, including:

Participation Requirements – All U.S. residents, 18 and over, can open and fund a 529 plan, regardless of income level. Typically, a parent or grandparent will open and fund the account naming the child or grandchild as the beneficiary. In the past, parent-owned 529 accounts were more favorable when completing the Free Application for Federal Student Aid application (FAFSA) than a 529 plan that was owned by a grandparent. However, the FAFSA has been redesigned for the upcoming 2024-2025 academic year, and now states that any distributions from a 529 plan owned by a grandparent will not count as income towards the student’s expected family contribution (EFC) calculation. This change should have a significant impact because FAFSA counts 50% of student income towards EFC.¹
Flexibility – Investment options in 529 plans can be tailored to an investor’s risk tolerance or based on a specific time horizon, with gradual adjustments as a beneficiary nears college age. Additionally, these plans allow a great deal of flexibility regarding beneficiaries and transfer of funds. For instance, account beneficiaries may be changed to a qualified family member and funds can be transferred or rolled into another 529 plan once per calendar year with no income tax liability or penalty.
Tax Advantages – Contributions to a 529 plan grow tax deferred and all earnings and withdrawals are tax free as long as the funds are used for qualified education expenses. If withdrawals are not used for qualified education expenses, the earnings will be taxed at the recipient’s tax rate and subject to a 10% penalty.
State Tax Advantages – Certain states allow tax deductions for contributions to the state sponsored plan. Check with your state’s plan to understand the tax advantages offered.
Gift and Estate Planning – Individuals may front-load, or ‘superfund’ a 529 plan by contributing 5 years’ worth of the annual gift tax exclusion amount in a single year.² In 2024, the annual gift tax exclusion is $18,000 per donor per recipient. This would allow contributions of up to $90,000 ($180,000 per married couple) per beneficiary in a single year without utilizing the lifetime gift-tax exemption. This can be an excellent technique for reducing one’s taxable estate. For example, if a married couple has 3 grandchildren, they could contribute up to $540,000 ($180K x 3) in a single year without reducing their lifetime exemption amount. In addition, assets contributed to fund a 529 account are not considered part of the account owner’s estate, thereby reducing one’s taxable estate. It is important to consult a tax advisor when considering this technique. Rules, amounts and eligibility may depend on the state in which the grantor resides.
Contributions – Once a 529 plan is established, anyone can contribute to the account up to the annual gift tax limit with-out incurring gift tax consequences. Furthermore, beneficiaries may have more than one 529 saving plan. Although there are no income limits for contributing to the plan, each plan has a lifetime contribution limit which ranges anywhere from $350,000 to $550,000 depending on the state.
Distributions – Withdrawals from a 529 plan do not have an annual limit and are tax and penalty-free if withdrawn for qualified educational expenses such as tuition and related fees, room and board costs, books and supplies, special needs equipment, and computers and related equipment. Any expenses paid from a 529 plan must be reported to the IRS, so it is very important to keep detailed records. Funds in a 529 plan may also be used to pay tuition and other qualifying costs for children in kindergarten through 12th grade, however there is a withdrawal limit of $10,000 per year.

If a beneficiary receives a scholarship, a nonqualified distribution from a 529 account can be withdrawn up to the amount of the awarded scholarship. Although the earnings on the withdrawal will be subject to taxes, no 10% penalty will be imposed.

Students who wish to study abroad may also use funds in the 529 plan to pay for qualified expenses, as long as the college is eligible for Title IV federal student aid. Tax-free distributions in this instance are subject to the same rules as traditional distributions in that they must be for qualified education expenses. Transportation and travel expenses are not considered qualified education expenses.

If the beneficiary enrolls in a school for the armed services such as the military, a non-qualified withdrawal may be taken from the 529 plan without incurring a 10% penalty. But the earnings would be subject to federal, state, and local taxes.

If non-qualified distributions are taken from a 529 plan, the withdrawal is reported as taxable income and subject to a 10% federal penalty on the earnings portion of the distribution. Examples of non-covered expenses include transportation and travel costs, health insurance, extracurricular activities, and college application and testing fees.

Excess 529 Plan Funds:

Sometimes a 529 plan may be overfunded, or the beneficiary may not need all of the funds available in the plan. For instance, a student might receive ample scholarships and grants, or a child may simply choose not to attend college. In situations like these, there are a few withdrawal strategies that can be implemented while minimizing taxes and penalties.

Beneficiary Changes and Leaving a Legacy – Fortunately, there are no time limits on the assets held within a 529 plan, so funds can continue to grow tax-free indefinitely. This means that the grantor may elect to maintain the account for future beneficiaries such as grandchildren or great grandchildren if not utilized by their own children. In fact, the account owner may elect to change the beneficiary to a qualifying family member at any time without tax consequences. Examples of a qualifying beneficiary include the current beneficiary’s sibling, mother or father, spouse, child (including stepchild, foster child, and adopted child), son-in-law or daughter-in-law, aunt or uncle, and niece or nephew. There are no limits as to how many times the beneficiary can be changed as long as he or she is a qualifying family member.
Roth IRA Funding - Beginning in 2024, beneficiaries of a 529 account will have the option to rollover up to $35,000, over the course of their lifetime, to their Roth IRA. This option became available under the SECURE 2.0 Act but has some limitations that are important to consider. Specifically, the 529 plan must have been open longer than 15 years, the owner of the Roth IRA must be the beneficiary of the 529 plan, and the annual contribution is subject to the same Roth IRA annual contribution limits ($7,000 in 2024). Unlike regular Roth IRA contributions, there are no maximum income limitations when rolling funds from a 529 plan to a Roth IRA, as long as the Roth IRA owner has earned income that is at least equal to the amount being rolled over.
Withdraw the Funds - Alternative options for excess funds in a 529 Plan are to simply withdraw the funds, or to gift the account assets to the beneficiary by transferring the ownership. Withdrawals for non-qualified expenses are taxed at ordinary income rates to whomever receives the distribution in addition to a 10% withdrawal penalty on the earnings portion of the distribution. If the account owner decides to transfer ownership, there is typically no income tax due. However, under some circumstances, a gift tax return may need to be filed, so it is important to seek guidance from a tax professional before initiating this process. The new owner would be able to keep the 529 plan to use for themselves or a beneficiary whom they designate, or to simply withdraw the funds subject to taxes and penalties.