Tag: Tax-Free Accounts
Saving with a 529 College Plan
August 30, 2021
As college students return to campuses this fall, they (and in many cases, their parents) face costs that have tripled in 20 years, with an annual growth rate of 6.8 percent.
Melanie Hanson at educationdata.org reports that the average cost of college (considered to be any postsecondary educational institution that offers an undergraduate degree program) in the United States is $35,720 per student per year. Current college cost data also reveal:
- The average in-state student attending a public 4-year institution spends $25,615 for one academic year.
- The average cost of in-state tuition alone is $9,580; out-of-state tuition averages $27,437.
- The average traditional private university student spends a total of $53,949 per academic year, $37,200 of it on tuition and fees.
- Considering student loan interest and loss of income, the ultimate cost of a bachelor’s degree may exceed $400,000.
In the academic world, the cost of college is generally referred to as the cost of attendance (COA). Each college has its own COA consisting of five items:
- Tuition and fees
- Books and supplies
- Room and board
- Personal expenses
Twice per year, the federal government recalculates the COA for each college and then adjusts the figures for inflation to determine students’ financial needs when they apply for financial aid.
Planning in Advance
Advance planning for education costs is advisable to keep ahead of college inflation.
Regular investments add up over time. By investing even a small amount of money on a regular basis in a college fund, you have the potential to accumulate a significant amount if you start when your child (or grandchild) is young.
Once you have a sense of your college savings needs, make sure you are investing the money appropriately. Among several available college savings options described by Fidelity, a great place to start is to open and contribute to a 529 college savings plan account. It’s popular with parents and grandparents because there are few restrictions and the benefits are plentiful. You can potentially reduce your taxes and retain control over how and when you spend the money.
Education savings plans were first created in 1986, when the Michigan Education Trust established a prepaid tuition plan. More than a decade later, Section 529 was added to the Internal Revenue Code, authorizing tax-free status for qualified 529 tuition programs. Today there are more than 100 different 529 plans available to suit a variety of education savings needs.
To make sure you are on track with your savings goals, and to ensure you have an appropriate investment mix, revisit your plan at least annually. Over time, you will likely need to update the costs of schools you are considering, your financial aid situation, your child’s school preferences, school location, and your investment performance. When you’re ready to start paying for school, withdrawals are federal income tax-free when used for qualified education expenses.
Setting Up and Using a 529 Savings Account
- The requirements to open a 529 savings account are simple. You must be a U.S. resident, at least 18-years old, and have a Social Security or tax ID number.
- 529 plan savings can cover a range of educational expenses, in addition to college tuition. You can use up to $10,000 from a 529 account each year per beneficiary on elementary, middle, or high school tuition. At the post-secondary level, money saved in a 529 plan account can be used for a variety of higher-education-related expenses: tuition and fees, room and board, books and supplies, and computers and related equipment.
- Money saved in a 529 plan may have only a small impact on financial aid eligibility.
- You don’t have to be related to the beneficiary on the account to open a 529 account for them. Friends or family members can open a 529 college savings account regardless of their income or relationship to the student—and can even name themselves as the student beneficiary on the account. Anyone can contribute and you can encourage donations to a college savings account as a birthday or holiday gift.
Reaping Tax Benefits
A 529 savings plan works much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds, ETFs (exchange-traded funds), and other similar investments. Your investment grows on a tax-deferred basis and can be withdrawn tax-free if the money is used to pay for qualified higher education expenses. Contributions are not deductible from federal income taxes.
You may also qualify for a state tax benefit, depending on where you live. More than 30 states offer state income tax deductions and state tax credits for 529 plan contributions.
Choosing a 529 Plan
Nearly every state has at least one 529 plan available, but you’re not limited to using your home state’s plan. Each 529 plan offers investment portfolios tailored to the account owner’s risk tolerance and time horizon. Your account may go up or down in value based on the performance of the investment option you select. It’s important to consider your investment objectives and compare your options before you invest.
Withdrawing from a 529 Plan
You can use your education savings to pay for college costs at any eligible institution, including more than 6,000 U.S. colleges and universities and more than 400 international schools.
Once you’re ready to start taking withdrawals from a 529 plan, most plans allow you to distribute the payments directly to the account holder, the beneficiary, or the school. Read “How to Pay Your Tuition Bill With a 529 Plan” to learn more.
Remember, you will need to check with your own plan to learn more about how to take distributions. Depending on your circumstances, you may need to report contributions to or withdrawals from your 529 plan on your annual tax returns.
Dealing with Leftover Funds
If your child doesn’t go to college or gets a scholarship, you won’t lose the college fund you have accumulated. Generally, you will pay income tax and a penalty on the earnings portion of a non-qualified withdrawal, but there are some exceptions. The penalty is waived if:
- The beneficiary receives a tax-free scholarship
- The beneficiary attends a U.S. Military Academy
- The beneficiary dies or becomes disabled
The earnings portion of the withdrawal will be subject to federal income tax, and sometimes state income tax.
If you have leftover money in your 529 plan and you want to avoid paying taxes and a penalty on your earnings, you have a few options, including:
- Change the beneficiary to another qualifying family member
- Hold the funds in the account in case the beneficiary wants to attend school later
- Make yourself the beneficiary and further your own education
- Roll over the funds to a 529 ABLE account, a savings account specifically for people living with disabilities
- Since January 1, 2018, parents also have the option to take up to $10,000 in tax-free 529 withdrawals for K-12 tuition
- Since January 1, 2019, qualified distributions from a 529 plan can repay up to $10,000 in student loans per borrower for both the beneficiary and the beneficiary’s siblings
You can withdraw leftover money in a 529 plan for any reason. However, the earnings portion of a non-qualified withdrawal will be subject to taxes and a penalty, unless you qualify for one of the exceptions listed above. If you are contemplating a non-qualified distribution, be aware of the rules and possible tactics for reducing taxes owed.
If you’re interested in setting up a 529 college savings plan, do your homework on the benefits, qualified uses for account balances, and the low impact on financial aid. File your findings and, once you start receiving account statements, keep track of your college saving account as it prospers.