529 plans offer a tax-free way to save for and pay educational expenses - here's how these state-sponsored investment accounts work

• 529 plans are state-run, tax-advantaged accounts earmarked for educational expenses, from kindergarten up through graduate school, and student loan paybacks.
• 529 plan account earnings and withdrawals are tax-free; some states also allow deductions on contributions.
• 529 plan funds can affect financial aid and can incur tax penalties if withdrawn for the wrong uses.

Paying for college, as everyone knows, is an expensive proposition - and the costs keep going up each year, even outpacing general inflation.

One strategic investment to deal with educational costs is the 529 college savings plan or 529 plan for short. It's a financial account that allows you to invest and earn money tax-free, then pay for eligible academic expenses - not just college, but a range of schools - without owing any taxes.

In a sense, it's like a specialized Roth IRA: Your funds are targeted towards a purpose and grow and be withdrawn tax-free. And also, that you could be penalized for ineligible withdrawals or uses of the money.

In this article, we'll share how a 529 plan is, why you should consider one, and what to watch out for.

What is a 529 plan?

A 529 plan is a tax-advantaged financial account. The money you contribute to it grows tax-deferred within the account. Withdrawals are tax-free when used for appropriate ("qualified" in IRS-speak) educational expenses: tuition, books and supplies, and room and board.

Traditionally, these accounts were designed solely to fund secondary education (i.e., a four-year college or university) tuition and related expenses. However, in the last few years, two pieces of legislation expanded their uses:

• The 2017 Tax Cuts & Jobs Act allowed 529 plan money to be withdrawn tax-free to pay for up to $10,000 per year of elementary, middle, and high school tuition.
• The 2019 SECURE Act allowed 529 money to apply to student loans (again, up to $10,000 annually), and also to expenses for technical and trade schools, and apprenticeships offered through community colleges.

While named for a section of the federal tax code, 529 plans are actually run by the states. You can establish one at a bank and or a financial services/investment company, like Fidelity, Vanguard, or T. Rowe Price.

Most accounts offer several investment options (usually mutual funds or ETFs, ranging from conservative to aggressive). Many also offer pre-defined portfolios, like target-date funds, that are age-based: They grow more conservative the closer your child gets to college age.

The 529 plan account is opened and owned by an adult on behalf of the child, who's deemed the account beneficiary. It does not have to be owned by the child's parent - grandparents are common 529 account-holders - but personal information for the child (e.g. date of birth and Social Security number) is necessary to open the account.

How much can you contribute to a 529 plan?

The IRS does not technically place a limit on how much you can contribute to a 529 plan. Basically, most people limit their annual 529 plan contributions to $15,000 per child. Married couples can each contribute $15,000 per child, for a total of $30,000 per year.

Here's why: Contributions to it are considered gifts, so most people plan their deposits to dovetail the annual gift tax exclusion of $15,000 per recipient in 2021. The annual gift tax exclusion allows people to give money, getting out of their taxable estate, without having to pay any gift tax.

For those who can afford it, it is possible to supersize contributions using the five-year election strategy. With this move, you can make five years' worth of contributions in a single year. In 2021, the election maximum is $75,000. This strategy provides an immediate reduction in your estate and enables more money to start growing tax-free in the 529 account right away.

If you opt for the five-year election strategy, you do have to report the gifts for each of the five years, on IRS form 709.

Tax deductions for 529 plan contributions

You contribute to a 529 plan with after-tax dollars - that is, you don't get a federal income tax deduction on the contribution at the time you make it. That's the trade-off for the balance growing tax-free.

However, you might qualify for a tax break on your state income tax return. Some 30 states allow at least some sort of deduction of your contribution. The amounts allowed by state vary widely and the maximum deductions range from a flat figure, like $5,000 per taxpayer, to a percentage of the contribution (like a 20% tax credit), to the full dollar amount of the contribution.

In these states, a 529 plan offers triple tax benefits. Your contributions are tax-deductible, the money grows tax-free, and withdrawals for eligible expenses are tax-free.

You may be able to establish a 529 plan outside of your home state. But of course, as a non-resident, you won't qualify for any state tax deductions or credits.

Potential drawbacks to 529 plans

As advantageous as 529 plans can be, there are some drawbacks to this college savings tool. You can face penalties for withdrawing the money for the wrong uses, the balances may affect financial aid, and it can get complicated if college plans change.

Are there penalties for withdrawing the money?

Yes, if you withdraw the money for an ineligible use - or withdraw too much money (in cases where you're limited to $10,000 a year), and the IRS finds out, you pay a 10% penalty on the amount withdrawn. Plus, you will have to pay taxes on any gains.

Will a 529 plan affect financial aid?

Yes, 529 plan accounts do factor into financial aid and scholarship considerations. The good news is that plans owned by a parent or another adult factor less into the financial aid equation than if the plan were owned by the student.

Also, the plan money counts as assets, and overall, a parent's income weighs more heavily into the calculation for financial aid eligibility than assets do. No more than 5.6% of parental assets are included, compared to 22% to 47% of a parent's income.

Assets held in someone else's name, like grandparents, don't count in financial aid considerations at all. However, 529 plan withdrawals from accounts owned by someone other than a parent are treated as non-taxable income for the student the following year.

If the child has won scholarships for their undergraduate degree, 529 money can be saved for graduate school or additional qualified education expenses later in life. Or to pay off student loans, if they incurred them.

What happens if a child doesn't go to college?

Since the use of 529 funds is earmarked for education, a child not attending or dropping out of school could be a problem.

However, there are options. The money can continue to grow tax-deferred in the 529 plan to be used at a later date - there's no time limit to them.

Also, a 529 plan can be transferred to another beneficiary, including yourself. As long as the new beneficiary is an immediate family member or family member's spouse, they qualify for a tax-free transfer of the 529 plan.

Most 529 plans allow the beneficiary to change once per year.

The financial takeaway

A 529 plan is a savvy way to save for any sort of secondary education, expensive private schools, or student loans.

The money grows tax-free and can be withdrawn tax-free for eligible educational expenses. You can withdraw any amount needed to meet academic university or trade school education costs. Withdrawals to pay K-12 tuition or student loans are limited to $10,000 a year.

If the child doesn't use the money right away, there are options. It can continue to grow tax-deferred for future educational expenses or be transferred to another relative without any tax penalties.

Worst case scenario: If you decide to withdraw the money for another, non-academic use, you'll owe taxes on any account gains and a 10% penalty. But you won't lose forfeit the funds, and you'll have gained the benefits of untaxed compounding on your money in the meantime.

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How to start saving for your kids to go to college, in 3 steps

Is college tuition tax deductible? Yes, you can reduce your taxable income by up to $4,000

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