Summary
- 529 plans are tax-favored accounts to pay for qualified educational expenses.
- There are 2 kinds of 529 plans, Prepaid Tuition Plans and Education Savings Plans.
- Financial aid eligibility is generally impacted by owning a 529 plan.
- SECURE Act 2.0 allows you to rollover 529 funds to a Roth IRA.
No doubt college can be an expensive ticket item to pay for, especially if your only funding source is yourself. I graduated college a while back when tuition was much less expensive so I don’t know the pains you may be going through today. I was fortunate enough to have parents that planned to pay for my tuition, which I’m ever so thankful for. You know how they saved up for it? Savings bonds. My Dad would hand me a savings bond every quarter to take to the bank, deposit in my checking account, and write my own tuition check to drop off at the admin building on campus. Savings bonds are now electronic, so you won’t be doing what I did. With the constantly rising costs of tuition, savings bonds aren’t going to cut it anyway. You need something more robust but what could that be?…
A 529 plan is a tax-favored account designed to pay specifically for qualified educational expenses. Legally, they’re known as “qualified tuition plans” and 529 is simply the section of the Internal Revenue Code. There are two types of 529 plans, the education savings plan and the prepaid tuition plan. For states that have state taxes, you may receive tax benefits from contributing to these accounts. Some states allow you to deduct their state taxes from contributions or give you tax credit if you use their in-state program. A list of states that offer tax benefits are listed below. If you reside in a state without state taxes, then this does not apply to you. We’ll talk about both along with how SECURE Act 2.0 affects these.
Prepaid tuition plans. These plans work exactly as the title indicates. You prepay for credits (or they’re sometimes called units), at today’s costs which include any mandatory fees. If you’re aware of how fast the tuition costs increase every year, I bet this sounds like a fantastic idea, which it is. These credits are typically available for use only in the states they are offered in at participating colleges and universities. That’s right, participating. Make sure any potential schools you may use them at accept them. Many of these plans have residency requirements as well. The credits are not guaranteed by the federal government however some state governments will guarantee them. If the plan sponsor becomes financially insolvent, you could lose some or all of your money. The plan sponsor is responsible for making sure the money you prepay today is worth the value of the future credit when you use it. The sponsor can be the state or a private company. How they do that is by investing the money you used to purchase the credits with. They can’t just go and invest in whatever they like. They must do so in a prudent manner so when the day comes for you to claim your credits it can pay for the future cost of tuition. But just like any business, they can fail for any number of reasons, hence the possibility of losing money. Not saying this will happen at all but if your comfort level falls below this you will want to look for ones with a guarantee. If you don’t use the credits at all, you can get your money back, but it won’t be the same value that you would’ve received if you had used them for credits. Each program has their way of calculating what that is. Don’t forget, there MAY be fees! Meaning, “We may not charge you fees but if we do, don’t be surprised.” These plans may charge an enrollment, application, or reoccurring administrative fees. With all this information, please check the finer details of the plan you’re looking at using to find out the specifics of it.
Education savings plans. These are basically the same as your standard investment account with a few tweaks. These are sponsored by states but managed by mutual fund companies. Almost every state has one. These plans work like a Roth IRA, except you’re using these funds for education expenses instead of retirement. Money you already paid taxes on is contributed to this account, it grows tax-deferred, and when you take it out to spend on qualified education expenses it’s tax-free. There are a couple ways to get the funds out of the account when it comes time to spend it. You can request a check be directly mailed to the school or to yourself. Either way, you want to keep records of everything. The tuition bill, how much the check was for, when it was sent, etc. It’s up to you to keep track of this information in case the IRS decides to audit where you spent these dollars. In addition to paying for tuition, these plans also include paying up to $10,000 per year per beneficiary for other qualified expenses. As I mentioned before, it’s an investment account but there are restrictions as to what you can invest in. Because these plans are offered by mutual fund companies, you can only use the investment selection they offer. In some cases, there is a lineup of exchange traded funds (ETF’s) which you may have access to as well if included in the plan. You unfortunately won’t have access to their full offering of funds but what they do have available will be more than adequate. Since these are investments, your money is not guaranteed and not FDIC insured. Like the typical investment disclosure, there is the potential to lose some or all of your money. Next, what can you expect to pay in fees? Whether it’s mutual funds or ETF’s, there are fees inherently built into these 2 investments vehicles. One of the fees is called an expense ratio. Each fund will have their own fee associated with them and it’s charged to you as an annualized percentage. These fees are deducted directly from the money you have invested with each fund you own in the account, so you’ll never see a bill for it. ETF’s are very cost effective when it comes to fees and that’s the only fee you need to worry about with them. Mutual funds are a little more complicated with costs. There is an option where you can pay an upfront sales charge on every penny you contribute. These are called A share mutual funds. There is an option with no sales charge. They are called C share mutual funds. The A shares will have a low expense ratio (usually not as low as an ETF though) and the C share will have a high expense ratio. The reason why you would choose one or the other depends on the timeframe. The way the math works out is if you’re going to spend the money in under 7 years, don’t pay the upfront sales charge. If you won’t spend the money for more than 7 years, pay the sales charge. The sales charge with a low annual fee will be more cost effective in the long run than no sales charge with a high annual fee and vice versa. If you’re unfamiliar with exactly how mutual funds work, I apologize as I plan to write a post on how they work but have not yet. Once I do, I’ll update this post and add a link. I hope this makes sense for now. Under current tax law you can only change investments twice per year in a 529 plan unless there is a beneficiary change. You can also rollover funds to another 529 account for the same beneficiary just like you would a 401(k).
What are qualified expenses? Tuition and required fees most certainly fit that description. Room and board if you’re living on campus. If you’re living off campus like most students do, you’ll only be able to cover the amount that it would’ve cost to live on campus. It’s almost always more expensive to live off campus. Books and supplies along with anything mandatory for the course. Computers and internet, along with peripherals like mouse, software, monitor. Under the Tax Cuts and Jobs Act signed into law December 2017, K – 12 tuitions at private schools are now considered a qualified expense up to $10,000 per year. However, not all states adopted this so check with yours before proceeding. Additionally, apprenticeship related expenses can be included. The program must be registered with the Secretary of Labor’s National Apprenticeships Act to qualify. Be careful, some items that you may think are a qualified expense may not be. Transportation, sports expenses, and health insurance are a few of those examples.
Financial aid impact. Generally, a 529 plan will impact eligibility to receive needs-based financial aid for college. It could also impact financial aid for elementary or secondary school tuition. Speak with your tax professional before opening an account if this applies to you.
What is SECURE Act 2.0? It stands for Setting Every Community Up for Retirement, and it is designed to help more Americans save for retirement. As you can see, they passed 2 of these into law, this one of course being an update to the first. This affects 529’s in a certain way and it’s for the better if you ask me. It allows you to transfer 529 funds to a Roth IRA based on these following stipulations. The 529 account must have been open for at least 15 years. The beneficiary and Roth IRA owner must be the same person. Rollovers are subject to applicable Roth IRA contribution limits though. Total lifetime rollover amount may not exceed $35,000. Rollovers may not exceed the amount contributed to the 529 account before the 5-year period prior to the rollover. Utah taxpayers should discuss with your tax professional how this affects you if you already have an existing plan through the state. There’s a stipulation specific to Utah plans. This rollover to a Roth can be a big deal. One of the primary concerns about 529 plans is having excess funds in the account after your child completes college or not having enough because you were worried about the afore mentioned problem. Excess at that point would have to be withdrawn under the penalty rules for not using it for higher education expenses which means taxes and penalties had to be paid. This shouldn’t be an issue now as the $35,000 is quite a bit to overshoot. On top of this, the SECURE Act expanded the definition of qualified expenses to allow repayment of student loans. A lifetime use of $10,000 per borrower can be used for this purpose. Additionally, it can be used to repay students loans of the beneficiaries’ siblings.
Let’s look at some statistics on these costs. The average cost of tuition for US colleges in 2023-24 is as follows: Private ~$42,100. Public out-of-state ~$23,600. Public in-state ~$10,700. Since 2010, the average college tuition inflation has increased about 12% annually while the cost of tuition at a 4-year public college has increased over 9% during that same timeframe. The main reasons are states have changes in local funding, there’s an increase in costs for educators, and colleges provide more student support services.
Think about this from a student loan standpoint. You often hear people say, “student loan is good debt.” Don’t listen to that. Debt is debt. Like any other loan you’re still borrowing money that you’re paying interest and interest is an expense to you. In 2023, the average student loan interest rate was 5.8%. Take 4 years of the in-state public school tuition which is $42,800, the average student loan term is 10 years, then add the interest. You’ll pay about $13,700 in interest over those 10 years. The more you can save for college now, the less debt you’ll have later. Well, most likely the less debt your child will have.
Here’s a list of states that offer some form of state income tax benefit. Italics are for states that offer a state income tax benefit even if you use an out-of-state 529 plan.
Alabama, Arizona, Arkansas, Colorado, Connecticut, Delaware, District of Columbia, Georgia, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Jersey, New Mexico, New York, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Utah, Vermont, Virginia, West Virginia, Wisconsin
