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Today I’ll share with you the basics of a 529 plan.  This plan operates as a savings plan for college that provides specific financial aid and tax related benefits. Many of today’s 529 plans are also used as a way to invest and save money for grade school tuition for grades K-12 as well as to cover college costs.

There are two options for 529 plans: the prepaid tuition plan and the college savings plan. Just about every state in the US offers a 529 plan. Private universities and colleges have their own 529 plan that they operate as well.

The History of the 529 Plan

When the first 529 plan came into effect, it was a prepaid tuition plan. It was created in 1986 by the Michigan Education Trust (MET).

Comparing 529 plans

The 529 plan got its name from the Internal Revenue Code (IRC) section 529. This section was added to the code in 1996. It was added to authorize the tax-free status of specific tuition programs that were qualified under the 529 plan.

When you earn under a 529 plan the earnings are accumulated on a tax-deferred basis. The distributions are not actually federally taxed when they are used to pay for expenses related to higher education. What qualified as higher education expenses in 2015 was expanded to include computers. In 2017 it was further expanded to pay for K-12 tuition for as much as $10,000 each year.

Can a 529 Plan Be Used To Pay for Any College?

You are allowed to invest in the 529 plan of any state, not just the plan in your own state. As long as the college is qualified, you can use this type of plan to pay for college expenses all across the nation.

For the most part in the majority of plans, the college you choose will not be affected by the state currently sponsoring your particular 529 college savings plan. As an example, if you are a resident of California but happen to invest in a plan in Massachusetts, but then send your student to school in South Carolina, you can still use this plan. 529 plans can be used in more than 6000 colleges and universities across the United States. They can also be used at more than 400 foreign universities and colleges.

If you have a specific college in mind, check their eligibility by looking at the 529 rules.

The States That Offer 529 Plans

At this stage of the game, most states offer a 529 plan. In fact, they all just about have one available plan. But each state has the ability to decide if they want to offer one or not. So different plans can differ depending on the state you happen to be looking in. Research the benefits and features of each plan prior to investing. It’s even possible to compare 529 plans online.

The Tax Benefits of 529 Plans

As long as the 529 plan meets certain basic requirements, federal tax laws dictate that special tax benefits exist like tax free qualified distributions and five-year gift tax averaging.

A number of states even offer state income tax incentives. The incentives include state income tax deductions and tax credits when contributions are made to the 529 plan in the state. So perform research to discover the best tax incentives of each plan in each state.

taxation

Two Types of 529 Plans

There are currently two different types of 529 plans. The categories include college savings plans and prepaid tuition plans.

  • College savings plans – this works very similarly to a Roth IRA or Roth 401(k). You invest your after-tax contributions into investments like mutual funds. There are a few different investment options available with 529 college savings plans. This type of plan could gain or lose value based on investment performance. So make sure to review your investment options for 529 plans to see past performance and previous rankings.
  • Prepaid tuition plans – with this plan, you can use the proceeds to prepay for some or all of your college costs for in-state public education. You can also convert these plans to use for out-of-state or private colleges. There is a 529 private college plan that offers a separate prepaid plan that is available for more than 250 private colleges.

Colleges and other universities can provide prepaid tuition plans but they cannot provide a college savings plan.

What Can I Use a 529 Plan for?

This type of investment account provides tax-free withdrawals and tax-free earnings growth. But this is only possible when you use these funds to pay for educational expenses qualified under the plan. This basically pays for computers, equipment, books, supplies, fees, and tuition for certain universities, colleges, and even certain postsecondary educational institutions. This plan is even sometimes capable of paying for room and board. You can make tax-free withdrawals for as much as $10,000 per year using this plan to pay for school grades K-12 for certain public, private, and religious institutions.

What Doesn’t Get Covered under a 529 Plan?

Since the 529 plan funds are yours, you can take them out and use them for any purpose you deem fit. But any of the earnings gained within the fund are not qualified as a distribution. So if you take out the earnings, they will be subjected to a 10% tax penalty as well as ordinary income taxes. There are exceptions in certain cases so look them up to find out more.

Generally speaking, the expenses needed to pay for enrollment in a qualified college are typically covered for college and postsecondary school. But there are certain costs that seem necessary but the IRS doesn’t feel they qualify as a necessary expense. Health insurance, transportation, and student loan payments are not looked upon by the IRS as qualified expenses.

Are the Contributions to a 529 Plan Considered Tax-Deductible?

Similar to a Roth IRA, contributions made to your 529 plan are deductible for federal income taxes and the contributions are post-tax contributions. Although Washington DC and 30 states do provide state income tax deductions as well as tax credits for 529 plan contributions. To qualify it’s possible you’ll be restricted to investing in the 529 plan offered by your home state because this is usually the only way to claim the benefit.

The funds inside of a 529 plan will grow tax-free. They aren’t going to be taxed or penalized unless you take the money and use it for something other than a qualified educational expense.

What Educational Expenses Are Qualified under a 529 Plan?

The educational expenses typically qualified under a 529 plan include:

  • books and materials
  • tuition and fees
  • computers and computer related equipment
  • equipment specifically needed for students
  • Internet access
  • room and board for students enrolled at least half the time

Costs not typically looked upon as educational expenses under the 529 plan include:

  • health insurance
  • student loan repayments
  • transportation expenses

Am I Allowed to Pay My Rent Using My 529 Plan?

When students are enrolled in a qualified university at least half the time, room and board is often looked upon as a qualified expense. As an example, the typical university and college consider six credit hours each semester as a half-time student.

For residents living on campus, expenses qualified as room and board cannot cost more than the amount the college charges for room and board. For off-campus students, the qualified room and board expenses are limited to “cost of attendance” amounts given by the college or university. Get in contact with your financial aid office to find out more information about this topic.

How to Use Your 529 Plan

After you begin withdrawing from your 529 plan, the majority of plans will give you the ability to distribute these payments to the account holder directly, the school, or the beneficiary. Certain plans might even let you make payments directly from your 529 account to various third parties like your landlord. Learn the specifics of your plan to find out more about distributions of payments.

Depending on your particular situation, it’s possible you’ll need to report withdrawals and contributions from your plan on your yearly tax return.

What Happens If the 529 Plan Doesn’t Get Used?

No one’s future is ever certain. Some adults worry about the investment made to their 529 plan. They are concerned that they might lose it if their child ends up getting a scholarship or chooses to forgo a college education.

Generally speaking, you’ll typically have to pay regular income taxes plus a 10% penalty on the portion of money earned within the 529 plan. Certain exceptions do exist as well so look into your plan to find out more about them.

The tax penalty is waived in certain situations if:

  • the account beneficiary is disabled or deceased
  • the account beneficiary receives a scholarship
  • the account beneficiary attends a United States Military Academy

All earnings will always be subject to federal income taxes. In certain cases they will be subject to state income tax as well.

What Happens When I Do Not Use the Money in a 529 Plan?

In an effort to avoid penalties and tax payments, your options include:

  • Roll the funds over to a 529 Able account, which is designed for people with disabilities.
  • Withdraw the money and use it to pay as much as $10,000 per year in K-12 tuition fees.
  • Change the beneficiary to another of member of your family who’s qualified.
  • Keep the money in the account just in case the original beneficiary decides to go to grad school.
  • Further your own education and make yourself the beneficiary.

What Happens If I Can’t Pay the Monthly Contribution Requirements?

The bulk of the 529 plans require a minimum initial contribution. The payment might be as low as $25 initially. But after the initial contribution requirement is up, you can put as much money in the account as you feel comfortable with.

Certain families set up automated monthly deposits. This is a nice set it and forget it option. Others prefer to make larger lump-sum contributions on holidays, birthdays and other occasions.

A 529 college savings plan is great because you can contribute to it whenever you want and you can contribute however much you want.

Tim Schmidt

About 

A Florida-based Entrepreneur, Author, and Life Hacker, Tim Schmidt decided to take control of his retirement portfolio several years ago by setting up a self-directed IRA. This blog shares his thoughts and opinions on the top of retirement and investments. You can follow his career and travels on his Official Website as well as on his Instagram page.

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