Many people tend to think of the 529 Education Savings Plan as a good way to save for their children’s or grandchildren’s education. And they’d be right.
But that’s where it ends for most people…and this is a potentially costly oversight. It can be much more powerful than that.
So what is the 529 and how does it work?
A 529 is a tax-advantaged savings plan designed to help pay for education.
How does it work?
The plans are funded with after-tax dollars, but all money taken out, which includes all the investment gains, are tax-free as long it is spent on qualified education expenses, expenses like: tuition, administration fees, books, room and board, computer, internet access, lab fees, etc., the list is quite extensive. Even for modest savers, the growth in a 529 account which grow tax free can easily equate to tens of thousands of dollars or more of additional money if set up and used properly.
How much can you contribute?
You can contribute up to $15,000 (the annual gift tax limit) per beneficiary per year. So for a couple, that would be up to $30,000 per year. However, the law permits each account owner to pay up to five years’ contribution upfront without triggering gift taxes, which means a couple can contribute up to $150,000 per beneficiary in one fell swoop. Wow. This $150,000 can then grow tax free every year.
In addition to this, there is no limit to the number of 529’s a person or couple can set up. A couple with a large family, say with 10 grandchildren could set aside $1.5 million (10 accounts x 150,000 max contribution). This $1.5 million is then excluded from their estate for taxes purposes – which can have a dramatic impact.
What happens if money is taken out for non-qualified expense or the original beneficiary (child/grandchild) doesn’t go to college?
The law permits the account holder to change beneficiaries as desired without penalty. This can be used should the original beneficiary not use the money. As an example, the beneficiary account could be transferred from child #1, to child #2, to grandchild #1, etc.
So in essence, you can move money across generations without taxes as long as you don’t hit gift tax exclusions. That’s a potentially powerful estate planning tool.
However, the power of the 529 account can still be very useful if the beneficiary doesn’t use the money for educational purposes. While there is a 10% penalty and taxes are due for amounts taken out for non-educational purposes, even factoring this in, the math shows the 529 account balances can be worth tens of thousands or more than simply putting the money into a regular brokerage account.
Some other notable highlights:
- 529 funds can be used for not only undergraduate college education expenses. The funds can be used for K-12th education, vocational & technical schools, certificate programs, graduate schools, and training for a new career from accredited institutions.
- Unlike income limits for contributing to other types of accounts (Roth IRA, etc.), there are no income limits for contributing to a 529 plan.
- If the beneficiary (child/grandchild) gets a scholarship or gets into a military academy, the law allows the account holder to take the amount of scholarship out of the account penalty free.
- The 529 assets can be taken out, called a “non-qualified withdrawal,” by the account holder at anytime. Under many scenarios the account will have more assets than having put the money into a taxable brokerage account. – Reread this sentence again.
- There are no limits to the number of 529 plans that can be established.
- There are no age or time limits as to when the money needs to be used, potentially allowing for decades of tax free growth.
- Only 5.6% of the value of the account is considered the parent’s assets for financial aid consideration.
- 529 accounts can be established with $0 account set up fee and $0 account maintenance.
Although 529 plans have been around for years, many people do not appreciate the flexibility they offer. While it’s a great savings tool for educational purposes, the accounts can be much more than that…it can be a part of a well thought out estate plan.
– Paul R. Rossi, CFA