Reviewing the Benefits of the 529 Savings Plan

by | May 29, 2024 | Financial Planning, Smart Finances

Let’s begin by talking about what a 529 Savings Plan is. It is defined by IRS publication 970 as a qualified tuition program (QTP). A QTP can help you to pay for education. I am deliberately not calling it a college savings plan because you can use it to fund so much more than college now.

The benefit of investing in a 529 Savings Plan is that earnings are tax-deferred, and earnings can be TAX-FREE if used for qualified education expenses!

QUALIFIED EDUCATION EXPENSES: tuition, room and board, books, fees, computers, and supplies for 2 or 4-year public or private colleges, trade schools, vocational schools, graduate schools, professional schools, K-12 schools (up to $10,000/year), apprenticeships, and student loan principal and interest payments ($10,000 lifetime limit per person).

How It Works

If you contribute $10,000 when the 529 Plan beneficiary is born, for example, and your investment yields 5% each year on average, you could have ~$24,066 to spend after high school on higher education. In another investment vehicle, you could owe taxes on the $14,066 in capital gains ($24,066 – $10,000 = $14,066). If you use the 529 Plan for qualified education expenses, you would owe nothing in taxes.

$10,000 invested for 18-years at 5% average annual rate of return ⋍ $24,066

Here’s another example. If you are able to contribute $90,000, and your spouse also contributes $90,000, and your investment yields 5% each year on average, you could have ~$433,191 tax-free to pay for higher education. That could cover an Ivy League education for four years (2024-25 tuition and fees at Harvard University are $82,866). That’s exciting!

$18,000 x 5 = $90,000 

(that 5-years forward funded at the 2024 gift tax annual exclusion rate of $18,000 per year)

$90,000 x 2 spouses = $180,000 

$180,000 invested for 18-years at 5% average annual rate of return ⋍ $433,191

Pros and Cons of the 529 Plan

But, what if you planned for your beneficiary to use these funds for education, and they don’t want to do that, or they’re not able to do that? Here are four more benefits of this Plan:

  1. You can roll over these funds to benefit another family member, even yourself.
  2. You can roll over these funds (within annual limits) to an ABLE account for the same beneficiary who became disabled before age 26.
  3. You can pay up to $10,000 in student loans for the beneficiary, as well as each sibling of the beneficiary.
  4. You can now, as of 2024, roll over up to $35,000 (lifetime limit) into a Roth IRA, which would yield tax-free retirement savings.

 There are, as you might imagine, just a few cons to this Plan:

  1. Like any investment, the returns are not guaranteed and there are fees and expenses associated with these accounts.
  2. There are many investment options available that cater to different risk tolerances and time horizons, though they are limited to specific choices for 529 Plans.
  3. If you withdraw these funds for anything other than qualified education expenses, you’ll pay ordinary income tax on the earnings PLUS a 10% penalty. If the beneficiary gets a full scholarship, the 10% penalty is waived.
  4. Contributions are not federally tax-deductible in the year they are made, though many states offer tax deductions or credits for contributions to their state-sponsored plans. 

How Will the 529 Plan Affect My Student’s Financial Package? 

The value of the parent-owned 529 Savings Plan is counted as an asset that is considered in calculating the Student Aid Index (SAI), which measures a student’s ability to pay for college, on the Free Application for Federal Student Aid (FAFSA). Anything over ~$10,000 in the account can count against you in consideration of financial aid. HOWEVER, there is a new loophole for grandparents, which is why the example above is especially fascinating when grandparents are able to make that 5-year forward funded contribution. Grandparent-owned 529 Plans are not counted as an asset in calculating the SAI on the FAFSA. Distributions regardless of ownership are also not considered student income in the year they are made.

Inflation is Crazy and College Tuition is Going Through the Roof

 The inflation rate for college tuition over the next 15-20 years is estimated to be 5% per year, though according to the College Board, recent years have seen a slowing in the rate of tuition increases. I highly recommend that you invest early in a 529 Savings Plan in order to utilize the tax-free compounded returns. There are other savings plans options, but none with the tax benefits and flexibility of the 529 Savings Plan.

Conclusion

The 529 Plan is one of my favorite products to talk to clients about because helping students graduate debt-free or with minimal debt is so important to me and because I love all of the possibilities that this Plan offers. It’s essential to understand the specific rules governing 529 Plan contributions and transfers, such as timing restrictions and eligibility requirements, to ensure compliance and avoid unintended tax consequences. Each individual’s situation may vary, so be sure to seek out advice before you take any action.