Retirement

What Is a 529 Plan?

When people talk about socking money away for their child’s proverbial “college fund,” they’re almost always talking about a 529 plan. What is a 529 plan? If you’re going to have significant upcoming educational expenses, this account is exactly what you’ll need to pay for them. It’s an investment account that helps you accumulate wealth to pay for qualified tuition programs. Used accordingly, it’s an opportunity to grow investments tax-free so you can cover the eventual cost of college or a similar higher learning experience. 

Whether you are raising a family and thinking about the future or are planning on going back to school yourself, a 529 plan is an important investment vehicle. Here’s what you need to know about opening and using these accounts and the stipulations for accumulating tax-free wealth. 

What is a 529 Plan?

How Does a 529 Plan Work?

Once you designate a beneficiary, a 529 plan functions much in the same way an IRA or brokerage account does. You can make contributions to the account at any time and invest the principal in a variety of vehicles, including stocks, bonds and funds. That money grows tax-free over time until it’s withdrawn to pay for qualified education expenses. 

There are actually two different types of 529 plans to consider. Each offers the same benefits to investors:

  • College savings plans. This is the traditional 529 account, as described above. Your vested balance can increase or decrease depending on the performance of the assets held within the account. 
  • Prepaid tuition plans. This is a more direct form of 529 account. It allows you to prepay education-related expenses to receive the tax benefits of a traditional 529 plan. Educational institutions often offer these plans directly.

There are also direct-sold 529 plans available through each state and advisor-sold 529 plans available through brokers. 

The chief thing to remember about a 529 account is that it’s specifically for education-related expenses. If you withdraw the funds for anything other than qualified education expenses, you subject yourself to federal income tax and a 10% penalty.

There’s no time limit on when the beneficiary of a 529 account needs to use the funds. Moreover, you can change the beneficiary if needed. 

What Are Qualified Education Expenses?

According to the IRS, qualified education expenses are “amounts paid for tuition, fees and other related expenses for an eligible student.” These expenses can include…

  • University or community college tuition
  • Vocational or trade school tuition
  • Elementary or secondary school tuition (up to $10,000 per year)
  • Room and board fees and off-campus housing
  • Food and meal plans
  • Textbooks, computers and other supplies
  • Online software and digital course materials
  • Special needs assistance (including equipment).

It’s extremely important for 529 investors to keep clear records and receipts when using funds to cover education-related expenses. In the event of an audit, the IRS will require proof of qualified education expenses. 

The Tax Advantages of a 529 Account

There are significant advantages to investing in a 529 account. The biggest and most obvious is the ability to invest after-tax dollars into an investment account that’ll grow tax-free. If the money is used to cover the appropriate expenses, investors won’t pay capital gains or income taxes on the returns generated by the account. This is as close to free money as you can get!

Because 529 contributions use after-tax dollars, they’re not subject to federal income tax deductions. That said, more than 30 states offer state-level deductions or credits for 529 contributions made to that specific state’s plan. 

A lesser-known opportunity to use 529 plans to your advantage comes through something called “super-funding.” Also known as five-year gift tax averaging, this maneuver allows investors to contribute a lump sum as much as five times more than the annual gift tax exclusion without incurring penalties. Excess counts proportionately over a five-year period. This is exclusive to a 529 account.

What Happens if the Beneficiary Doesn’t Go to College?

Many parents start saving for their child’s education while they’re an infant. But what if they don’t grow up to attend college or go on to higher learning? If life throws you a curveball, 529 plans make it easy to adapt. Owners have options:

It’s worth remembering that, while they may incur a 10% penalty, investors can withdraw funds from a 529 account for any reason. There are caveats to that penalty as well. There is no penalty in the event the beneficiary…

  • Enlists in the United States military or a military academy
  • Receives a tax-free scholarship to a qualified learning institution
  • Dies or becomes disabled.

In the event any of these situations occurs, you’ll still need to pay tax on the earnings gained in a 529 account. In many cases, it’s best to consider alternative options before withdrawing and eating the taxes and/or penalties.

The Bottom Line on 529 Plans

What is a 529 plan? If you have a child who will someday attend college, a 529 plan is the best investment vehicle to help pay for higher learning expenses. Your money will grow tax-free over time, and you won’t pay tax on the returns so long as they cover qualified education expenses. And, with qualified expenses spanning from tuition to room and board, your beneficiary will have plenty of use for the wealth generated by a 529 plan.

It may be important to you to protect your children’s growth with a 529 plan. But it’s also important to protect your own future in retirement. Therefore, sign up for the Wealthy Retirement e-letter below. You can learn how to retire on your own terms with sustainable passive income streams.


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