529 Plans: How to Save Tax-Free for Your Child’s Future
TL;DR: 529s are a way to invest and have your money grow tax-free, as long as you spend it on qualified education expenses.
Most posts on the internet are INFURIATING because they’re so long and just don’t get to the point. You need to read multiple blogs to get all the info you need. Here, I will have a very short point-by-point summary of the basics, for the maximal useful material/words ratio.
What is a 529? An investment account run by states where you can grow funds tax-free, as long as you withdraw and eventually spend the money for qualified education expenses. Each state will have their own program, but most of the time you can open one in any state you like.
What are qualifed expenses?
- Tuition and fees (limited to $10k/year for K-12, no limit for college)
- Books and supplies (college only)
- Computers and internet (college only)
- Room and board (college only, student enrolled at least part-time)
- Special Needs Equipment (college only)
- Student loans ($10k lifetime limit)
Who can use it? You can open an account and put down basically anyone as a beneficiary.
What if you don’t have children/reasonable beneficiary candidates? You can open an account in your own name and change the beneficiary later.
CAUTION: if you do this, and you change the beneficiary of a different generation (e.g. beneficiary changed from you to your child), you may run into federal gift tax consequences.
What if your beneficiary doesn’t need it anymore? You can change the beneficiary up to twice a year whenever you want (e.g. if your son decides not to go to college, you can change the beneficiary of your plan to your daughter). The new beneficiary must be a “family member” (a google search would give you the whole list of candidates, but something like parents + siblings + descendants + nieces and nephews covers most of what you may want).
What investment options are there? You are basically limited to your plan’s ETF/Mutual Fund-like offerings. Careful with the expense ratios (which can range from single digit bps to near 1%, please do your own research on your plan before investing).
Is it SIPC insured? No.
How much can I contribute every year? Technically no yearly limit. However, any contribution you make counts as a “gift”. In general, if you “gift” over your yearly gift exemption of $15k to any person you start using your >$11.7 million (for tax year 2021) lifetime exemption. Once you use up all your exemptions, you pay between 18-40% to the IRS on the amount you give. Note that for 529s, you can front-load up to 5 years of yearly exemptions (so you can contribute $75k off the bat if you wanted to).
Careful though, each plan has an overall limit (usually a couple or a few hundred thousand) that you cannot breach. This is meant to cap account sizes to not exceed what can reasonably be used for college costs. Please look up your plan to figure out what your cap is.
Does this affect financial aid? Short answer, technically yes but not really. Assuming you are a parent contributing to a child’s education, a 529 is considered part of the parents’ net worth and impacts your child’s financial aid at a maximal rate of 5.64% (in 2021, at the time of this writing). This is the same rate as if you held stocks in a taxable brokerage account, and much lower than if you gifted your child some assets.
However if you are not a parent (say, a grandparent) things become more hairy. The overview is something like the funds don’t affect financial aid until you withdraw it to cover the educational costs, but then it counts as a student asset (which is worse for you in the financial aid calculation). Please do your own research if this applies to you.
What are some other benefits? Some states offer a tax deduction. Seven “parity” states (listed below) offer income tax deductions no matter where you open a plan, if you live in these parity states. Others will offer a tax deduction/credit if you open it up and it’s your home state, others still have no benefits. You’ll just have to look up your own state’s programs.
Parity states:
- Arizona
- Arkansas
- Kansas
- Minnesota
- Missouri
- Montana
- Pennsylvania
What are some alternatives? Check out the Coverdell ESA. You can contribute up to 2k, there is an income limit to contribute (although it’s likely you can backdoor into it). Investments are self-directed, and you can use the funds more freely for education K-12. However, the account needs to be open for someone younger than 18 and must be withdrawn by the time the beneficiary turns 30. You can change beneficiaries whenever.
As always, this is meant as a primer on the subject, but this is not investment advice. Please do your own research before opening an account/investing!
Have more questions? Let TheJKW know!
Happy 529’ing,
TheJKW