As a parent, you are constantly searching for ways to provide your child with the best possible beginning in life. You have likely considered their education and may have even begun saving for it. However, have you considered the potential of a 529 savings plan? This investment option has tax advantages and could be the solution to securing your child’s future. What exactly is it, and how does it function? Let’s dive into the world of 529 savings plans.
What is a 529 Savings Plan, and how does it work?
A 529 savings plan is an investment account designed to help families save for future education costs. Named after Section 529 of the Internal Revenue Code, these plans come with significant tax benefits, making them an attractive choice for many parents. If you’re wondering how to create a 529 savings plan for your kids, we can help.
529 Savings Plan Tax Benefits
One of the most appealing features of a 529 plan is its tax benefits, which are available in three main forms.
Tax-Free Growth
The investments in your 529 plan grow tax-free. With this plan, you can avoid taxes on capital gains, dividends, and interest earned. This plan dramatically boosts the amount of money you save compared to a taxable account.
Tax-Free Withdrawals
Withdrawals from a 529 plan are not subject to federal income tax as long as you use them for qualified education expenses. These expenses include tuition, fees, books, supplies, and equipment required to enroll or attend an eligible educational institution. They can also include expenses for room and board if the beneficiary is enrolled at least half-time. Some states also offer tax-free withdrawals.
State Tax Deductions or Credits
Did you know that more than 30 states, including the District of Columbia, offer a tax deduction or credit for contributing to a 529 plan? However, each state has its own rules, so it’s crucial to verify the specific tax benefits available in your state.
It’s worth noting that if you withdraw money for non-qualified expenses, you’ll be liable for federal income tax, and you may have to pay a 10% penalty on the earnings portion of the withdrawal.
Furthermore, if you received a tax deduction or credit from your state for contributing to the plan, you may have to repay the state tax benefit if you withdraw money for non-qualified expenses.
Remembering that tax laws can be complicated and subject to change is essential. That’s why it’s always a good idea to consult a qualified tax advisor or financial planner before investing in a 529 plan.
Compound Interest
Compound interest is a powerful concept that applies to many investment accounts, including 529 plans. It’s often called “earning interest on interest” and can significantly increase the money you accumulate over time.
Here’s how compound interest works in a 529 plan:
When you contribute money to a 529 plan, you add money to your chosen investment options, such as mutual funds. These investments have the potential to earn a return, which could be in the form of interest, dividends, or capital gains.
Suppose you keep the earnings (including interest, dividends, and capital gains) in the account and not withdraw them. In the following period, you earn a return on your initial contributions and the earnings generated. This concept is compound interest.
For example, putting $1,000 into a 529 plan grows by 7% over a year. By the end of the year, you’ll have $1,070. If you leave all that money in the account and it grows by 7% again the following year, you’ll earn about $75 in interest. That’s because you’re earning $1,070, not just your original $1,000.
It is a good idea to begin saving for college as early as possible, as the longer your money remains in the account, the more it can grow. One of the significant benefits of a 529 plan is that the earnings are not subject to taxation. This benefit allows your compound interest to remain in your account, contributing to faster money growth.
How to Create a 529 Savings Plan
Don’t be intimidated by setting up a 529 savings plan – it’s pretty straightforward. Regardless of where you live, most states have 529 plans that anyone can open. Plus, some states offer tax breaks for contributions to their plans. Select a plan from a financial institution via your state’s program to get started.
After selecting a plan, you must fill out an application with personal information regarding the account owner and beneficiary. In the event of an unborn child, the account owner can act as the beneficiary until the child is born; at this point, they can then be named as the beneficiary.
Once you’ve finished the application, you can fund the plan. You have several options to choose from: you can mail a check, transfer money electronically, or set up automatic contributions. Although there are no annual contribution limits for a 529 plan, there may be minimum contribution requirements.
When selecting your investments in a 529 plan, you have two options: age-based or static portfolios. It’s essential to consider factors such as the plan’s performance, state, and associated costs when deciding where to open your 529 plan.
The Power of Contributions
A great benefit of a 529 savings plan is that it enables you to receive contributions from others. Instead of giving your child a toy on Christmas or their birthday, direct family members to contribute to your child’s 529 plan. Gradually, these contributions can accumulate and create a significant fund for your child’s education.
Several 529 plans have online gifting platforms that make it convenient for others to contribute. By creating a profile for your child and sharing a link with family and friends, they can directly contribute through the platform.
Making a Contribution to a 529 Savings Plan
Once you create an account, you can start making contributions. Many plans offer various contribution methods, such as checks, electronic bank transfers, payroll deductions, or direct deposit of state tax refunds. Although there is no annual contribution limit for a 529 plan, lifetime limits differ depending on the state, typically ranging from $235,000 to $529,000.
It’s important to note that while anyone can contribute to a 529 plan, the account owner controls the funds. Therefore, if you’re contributing to a plan that someone else owns, you should be comfortable with their management of the account.
Can you use a 529 Savings Plan to pay off student loans?
Starting in 2019, using a 529 plan to pay off student loans is now possible. This change was made as part of the SECURE Act, signed into law in December 2019.
With the SECURE Act, 529 plan distributions can be used to pay off the principal and interest of qualified education loans for the beneficiary of your 529 plan or any of the beneficiary’s siblings. The lifetime limit for this use of funds is $10,000 per individual.
If you have funds remaining in your 529 plan after using them to pay for college expenses, you can use that money to help pay off student loans without any taxes or penalties.
Can I roll a 529 savings plan into a Roth IRA?
In December 2022, the SECURE 2.0 Act was passed, changing the rules governing 529 accounts. As a result, individuals can now roll over up to $35,000 into a Roth IRA.
Other College Savings Options
A 529 savings plan is excellent for your child’s education, but there are other ways to save. These include high-yield certificates of deposit (CDs), individual retirement accounts (IRAs), and taxable brokerage accounts. Each option has pros and cons, so assessing your needs and circumstances is crucial before deciding on a savings plan.
The Downsides of a 529 Plan
When making any financial decision, it’s essential to consider the potential drawbacks. One of the main downsides of a 529 plan is the penalty for withdrawing funds for non-qualified education expenses. If you choose to withdraw money for something other than qualified education expenses, you will be subject to income tax and a 10% penalty on the earnings portion of the distribution.
Another potential issue is the impact on financial aid. If you or your dependent student owns a 529 plan, it will be considered a parental asset on the Free Application for Federal Student Aid (FAFSA). This asset could affect your child’s eligibility for need-based financial aid.
Lastly, some individuals may find the investment options in a 529 plan limiting. Unlike a regular brokerage account, which allows investment in virtually any stock, bond, or mutual fund, a 529 plan restricts investment options to those offered by the plan.
The Bottom Line
Investing in your child’s future through a 529 savings plan is a powerful decision that requires thoughtful planning. Although it may require careful consideration, the potential benefits are worth exploring. It’s necessary to keep in mind that the best time to start saving for your child’s education is now. So, take action today and begin exploring your options to unlock the full potential of a 529 savings plan for your child’s future.
