Understanding the ins and outs of a 529 college savings plan may help you unlock one of the biggest bangs for your college-savings buck.
A 529 college savings account offers many advantages.
While there are several ways to save for college—such as opening a custodial account (Uniform Gifts to Minors Act [UGMA]/Uniform Transfers to Minors Act [UTMA] account), a Coverdell Education Savings Account (ESA), or even setting money aside in a taxable account (see the detailed chart below)—few would argue with the potential advantages of a 529 college savings plan.
Designed specifically to help pay for qualified costs associated with higher education, a 529 college savings plan is a tax-advantaged account that allows for distributions to pay for things like tuition, fees, books, supplies, and any approved equipment the student may need to study at accredited institutions. In addition, you can take distributions for room and board, as long as the beneficiary of the plan is attending the school at least part time. When 529 funds are used for these qualified purposes, there is no federal income tax on investment gains (no capital gains tax, ordinary income tax, or Medicare surtax).
Typically, a parent or grandparent opens the account and names a child or loved one as the beneficiary. Each plan is sponsored by an individual state, often in conjunction with a financial services company that manages the plan, although you don’t have to be a resident to invest in a state’s plan.
Don't miss out on state tax advantages.
Some plans offer additional state tax advantages to their state residents. Still, it's important to research different plans outside your state to see whether it's worth giving up other features (e.g., certain investment options or fund managers) in order to get the state tax advantage.
Minimal impact on financial aid. Many families worry that saving for college will hurt their chances of receiving financial aid. But, because 529 college savings plan assets are considered parental assets, they are factored into federal financial aid formulas at a maximum rate of about 5.6%. This means that only about 5.6% of the 529 assets are included in the expected family contribution (EFC) that is calculated during the federal financial aid process. That’s far lower than the 20% rate that is assessed on student assets, such as assets in an UGMA/UTMA (custodial) account. Learn more about how the EFC is calculated.
“This lower rate means that every dollar saved in a 529 college savings plan can go a long way toward helping to pay for college without significantly affecting financial aid,” says Keith Bernhardt, vice president of college planning at Fidelity Investments. “What’s more, earnings from a 529 college savings plan used to pay qualified education expenses will not be considered part of parental or child income that would otherwise reduce future financial aid eligibility. This is not the case for taxable savings options.”
One important caveat is the difference in treatment if someone other than the parents or student—such as a grandparent—owns the 529 plan. In that case, while these 529 savings are not reported as a student asset on the Free Application for Federal Student Aid (FAFSA), any distribution from this 529 plan is reported as income to the beneficiary, potentially resulting in a significant reduction in eligibility for need-based aid the following year. If they’re available, consider using funds in a 529 plan owned by a nonparent for the last year of college, after the last financial aid forms are filed.
More control for the account owner. Unlike a custodial account that eventually transfers ownership to the child, with a 529 college savings plan, the account owner (not the child) calls the shots on how and when to spend the money. Not only does this oversight keep the child from spending the money on something other than college, it allows the account owner to transfer the money to another beneficiary (e.g., a family member of the original beneficiary) for any reason. For example, say the original child for whom the account was set up chooses not to go to college—or doesn’t use all the money in the account—the account owner can then transfer the unused money to a named beneficiary.
Greater flexibility. In many ways, a 529 college savings plan has fewer restrictions than other college savings plans. These plans have no income or age restrictions and have no upper limit on annual contributions, unlike the Coverdell ESA, which limits contributions to $2,000 annually and restricts eligibility to those with adjusted gross income of $110,000 or less if single filers, and $220,000 or less if filing jointly. However, once a 529 plan account reaches a certain value—typically more than $300,000 (varies by state)—further contributions are not permitted.
Anyone can open and fund a 529 college savings plan, including parents, grandparents, relatives, and family friends. You may even open one to pay for your own college expenses.
Investment choices. Each 529 college savings plan offers its own range of investment options, which might include age-based strategies; conservative, moderate, and aggressive portfolios; or even a mix of funds from which you can build your own portfolio. Typically, plans allow you to change your investment options once each calendar year or if you change beneficiaries.
“Whatever age-based portfolio you choose, the first step in the process is defining the investment objective,” says Peter Walsh, institutional portfolio manager for the Fidelity-managed 529 plans. “With appropriate, age-based investments, the objective is to achieve a vehicle for asset accumulation, while maintaining a balance between risk and return.”
Think carefully about how you invest your savings. A strategy that’s too aggressive for your time frame could put you at risk for any potential losses that you may not have time to recoup before you need to pay for college. Being too conservative can also be a risk because your money may not grow enough to meet costs.
“This is where an age-based strategy may really help people who don’t want to actively manage their investments, because it maintains a mix of assets based on when the beneficiary is expected to start college and rolls down the risk as that time gets closer,” says Bernhardt.
Who may want to consider a 529?
Anyone with children or grandchildren likely going to college, whether they are babies or teenagers, may want to consider investing in a 529 college savings plan. The sooner you start, the longer you have to take advantage of the tax-deferred growth and generous contribution limits.
Investors also may want to consider setting up regular, automatic contributions to take advantage of dollar cost averaging—a strategy that can lower the average price you pay for fund shares over time and can help mitigate the risk of market volatility. Besides, many investors don’t have the financial capacity to make meaningful, lump sum contributions to a 529 college savings plan.
“It cannot be stressed enough that asset allocation cannot solve poor savings behavior,” Walsh says. “Regular, disciplined saving is the most important factor in growing the amount you put away for college.”
Potential tax benefits
As mentioned earlier, for distributions from a 529 used to pay for qualified higher education expenses, no federal income taxes are owed on the distributions, including the earnings. This alone is a significant benefit, but there are other tax benefits as well.
A 529 college savings plan may offer added estate planning benefits. “Any contributions made to a 529 college savings plan are considered ‘completed gifts’ for estate tax purposes, so they come out of your taxable estate, even though the account remains under your control,” Bernhardt says.
Gifts to an individual above $14,000 a year typically require a form to be completed for the IRS, and any amount in excess of $14,000 in a year must be counted toward the individual’s lifetime gift-tax exclusion limits (the federal lifetime limit is $5,340,000 per individual). With a 529 plan, you could give $70,000 per beneficiary in a single year and treat it as if you were giving that lump sum over a five-year period.1 This approach can help an investor potentially make very large 529 plan contributions without eating into his or her lifetime gift-tax exclusion. Of course, you could make additional contributions to the plan during those same five years, but these contributions would count against your lifetime gift-tax exclusion limit.
Being smart about the way you save for college also means being mindful of your other financial priorities. “Fidelity believes that retirement saving should be a priority, because while you can’t borrow money to pay for retirement, you can for college,” Bernhardt says. Still, if college saving is among your financial goals, choosing to invest in a 529 college savings plan may be one of the most educated decisions you can make to help pay for qualified college costs.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917