Putting together a college savings plan can be daunting. The rapidly rising cost of higher education can be intimidating, but don’t let the numbers scare you off.
According to the College Board, the average per year cost of a private four-year college is $39,400 compared to $10,950 for a state school.
If college expenses continue to rise at a higher rate than overall inflation, the cost will be much more 10 to 15 years down the road. These amounts leave many wondering if they’ll ever be able to save enough.
With careful planning and discipline, you have a much greater chance of making it happen.
529 College Savings Plan Basics
These plans are tax-advantaged investment accounts to promote saving for college. At least that’s what they were originally intended for. Recent legislation expanded their use for K-12 education and other educational programs. Simply put, they’re not just for college anymore.
These accounts don’t need to be for your own children. While that may be the most common scenario, you can set them up for almost anyone. The beneficiary needs to be a U.S. citizen or resident alien.
Tax advantages of 529 plans
These accounts have special tax benefits, similar to Roth IRAs. Money you sock away allow for tax deferred growth and tax-free withdrawals for qualified education expenses. In ordinary investment accounts, earnings like dividends and realized capital gains are subject to taxes.
Taxes chip away at your investment returns. Saving for future educational expenses with this special tax benefit allows more money to stay in your pocket.
There is no federal income tax deduction for contributions to a 529 plan. Don’t let that scare you off. This is similar to how tax-free Roth IRAs work.
State income taxes are a different story. State income tax deductions or credits are offered by most states. But there’s a catch. You must contribute to your state’s 529 plan. A small number of states will allow state income tax deductions if residents contribute to other states’ plans.
It can be easy to go down this rabbit hole but don’t let it distract you. 529 benefits for federal taxes is reason enough to give them a look. Consider the state tax benefits the icing on the cake.
How to open and contribute to a 529 plan
Once you’ve chosen the investment provider, opening a 529 plan investment account is easy. Most investment firms allow you to open an account online and establish a link to your checking or savings account.
You can start saving for college with as little as $25 per month. Obviously, that isn’t going to cover all of the education expenses down the road. However, a little bit over a long period of time adds up to a lot!
How to invest in a 529 college savings plan
As the account owner, you are responsible for matching your investment objectives with an appropriate mix of investments. This is most often accomplished with investments in mutual funds.
How you allocate the investments of the portfolio between high and low risk mutual funds depends on a few things. First, how many years until the funds are needed? Are you setting the account up for a newborn or a freshman in high school? Second, what is your comfort level with risk.
In general, the closer you are to needing to pay for qualified education expenses, the less risk you should take with the mutual funds.
If you’re going to be investing funds for the short term like 1 to 3 years, you should steer clear of the stock market and stick with CDs despite the low rates.
If you are investing with a longer-term time horizon, it would be completely prudent to allocate a portion of your investments to stocks. While CDs and a savings account are very low risk, they may not be the best bet for returns over the long term.
If you’re not comfortable making those investment decisions, the investment manager wil automatically adjust the portfolio to become more conservative as the beneficiary nears college age.
529 plan costs
Not all 529 plans are created equal when it comes to fees. Some are low cost and others, not so much. You need to look at annual charges and the expense ratio of the funds. This is expressed as a percentage. Anything with an expense ratio over 1.00% is suspect.
The good news is that competition in this space is fierce. This has led to reduced fees and costs for consumers. As a Certified Financial Planner™ and fiduciary advisor, I prefer low-cost investments. Whatever you save in fees will stay right in your pocket.
qualified educational expenses
What you can spend 529 plan money on is broad. In general qualified educational expenses included tuition, room and board, technology, special needs resources, and school supplies.
What if I don’t spend the money on college?
You don’t have to spend the money on college, but the expenses do need to be qualified educational expenses.
In general, if you use funds within a 529 plan for anything other than qualified educational expenses, there will be taxes and penalties on the portion that is considered a gain.
For example, if you have $10,000 left in an account and $8,000 represents your investment (or principal), you would be taxed and penalized on the $2,000.
That $2,000 will be subject to federal income tax, a 10% penalty, and potentially state income tax. Total financial hit can be as high as $730 or more.
It’s important to note, the tax rate used to assess the penalty is that of the beneficiary. Most often, the beneficiary will be at a lower tax rate than the parent.
exceptions to the 529 plan withdrawal penalty
There are several exceptions when it comes to penalties for 529 plans. However, you still pay federal income tax. They include scholarship, military service, disability, and death.
Important tax changes
In 2024, new rules allow for unused balances in a 529 plan can be rolled over to a Roth IRA. This is a significant change that will allow people to avoid costly penalties.
However, there are restrictions:
- Rollover would transfer to the beneficiary’s Roth IRA, not the parent or account owner.
- You can’t rollover contributions or the earnings from the last five years.
- Rollovers are limited to the annual contribution limit ($7,000 in 2025)
- The 529 needs to have been in existence for 15 years.
- $35,000 cap for Roth IRA rollovers
The beneficiary can be changed
There is often concern about what to do with the funds if your child doesn’t go to college or use the funds for other qualified education expenses.
Beneficiaries can easily be changed. If you spend the 529 funds on the new beneficiary’s education expenses, you will avoid the taxes and penalties.
If the 529 plan is not a UTMA, you can change who will be the recipient of the funds. Some 529 plans have been funded via UTMA accounts. This is where funds have been gifted to a minor for their benefit.
At the age of trust termination, the minor takes control of the funds. If the 529 plan was funded with a UTMA account, you cannot change the beneficiary.
IRA Tax Form 1099-Q
This has been a confusing topic for many parents with 529 accounts for their kids. There is no requirement that expenses be paid directly to the educational institution. Account owners are free to reimburse themselves for qualified higher education expenses.
As a result, where the distribution is sent determines who receives the 1099-Q tax form. If distributions from the 529 were paid directly to the educational institution, the 1099-Q will go to the student. If the distribution was sent to a parent for reimbursement, the parent will be sent the 1099-Q.
Whoever the 1099-Q is made out to is responsible for reporting it on their tax return. However, that only comes into play when the distribution is taxable.
1099-Q When The 529 is a UTMA
This is where things get a little tricky. Many people had UTMA accounts for their kids and then later converted them to 529 accounts. By doing so, these 529 accounts maintain their UTMA legal structure. Stated another way, the minor is both the owner and beneficiary of the 529.
As a result, no matter who received the distribution (school, parent, or student) the 1099-Q goes to the student (minor). As in the prior example, it is still only reported on the tax form if it’s a taxable distribution.
Start Saving Now If You Haven’t Already
Don’t wait to have everything figured out before to start. You can work out the details and fine tune as you go. Don’t let analysis lead to paralysis.
If you’re currently at zero dollars per month, start with $25. You don’t need to be an expert and sort through all the different types of account before you start.
Frequently Asked Questions About 529 College Savings Plans
Qualified education expenses include tuition, fees, room and board, textbooks, computers, internet access, and certain K–12 costs. Recent law changes also allow use for apprenticeships and some student loan repayments.
Yes. If the account is not a UTMA-funded 529, you can change the beneficiary to another qualified family member. If the account is a UTMA/529, the funds legally belong to the child and the beneficiary cannot be changed.
Form 1099-Q reports distributions from a 529 plan.
If the payment goes directly to the school, the student gets the 1099-Q.
If the account owner reimburses themselves, the owner gets the form.
In a UTMA/529, the 1099-Q always goes to the student because they are both owner and beneficiary.
Yes, starting in 2024, certain unused 529 balances can be rolled over to a Roth IRA for the beneficiary, up to $35,000 lifetime. Restrictions apply, including a 15-year minimum account age and annual contribution limits.
If funds are used for non-qualified expenses, earnings are subject to federal income tax, a 10% penalty, and possibly state tax. Exceptions apply for scholarships, military service, disability, or death.
529 College Savings Plan – Conclusion
College costs are steep. It’s not just the cost of tuition but room and board as well. If you’re already saving, look for ways to make a small increase.
The failure to start saving or even delaying it by a couple of years can make a huge difference. Once you start the 529 plan, you’ll be amazed at where you can find some extra dollars here and there.
Rome wasn’t built in a day and neither will your college fund. Over time, it will grow. Will the funds be needed in 5, 10, or 20 years? The answers to those questions will be your guide. A 529 plan will help get you there.
Have you considered how a Certified Financial Planner™ can help you with college planning?
