Funding college expenses for children remains a primary savings goal for many adults. 529s are one of the most effective college savings plans because of the flexibility and significant tax benefits they provide. But like any investment vehicle, there are important considerations you need to keep in mind.
The sooner you start saving in a 529 plan, the more you can accumulate for the benefit of the students you seek to support.
Here are five facts about 529 plans you should know when considering your options:
The tax advantages are important
529 plans are similar in structure to Roth IRAs. You make contributions in after-tax dollars. In more than half of all states, income tax deductions or credits are available to those who pay dues. Income generated under the 529 plan increases with a tax deferral. Then, when the money is needed for eligible education expenses (see below), you can withdraw funds tax-free.
Contribution limits are high
Although often compared to IRAs, 529 plans have the advantage of being able to set aside much larger sums. There are no annual contribution limits, but your state will limit aggregate funds in 529 plans, ranging from $235,000 to $542,000. You can invest large lump sums or make regular monthly contributions to a plan. The only limitation to keep in mind is the annual gift tax exclusion of $15,000 (in 2021). Any amount invested in a 529 plan greater than that in a given year is applied to your lifetime gift tax exclusion, which now totals $11.7 million (in 2021). However, you are allowed to make a single contribution up to $75,000 (in 2021) for a beneficiary in one year instead of five annual contributions up to $15,000 without using any of your lifetime tax exclusions.
Contributions can come from various people
Parents are frequently the initiators of 529 plans, but not always. These plans allow virtually anyone to make contributions for the benefit of a chosen person. Very often, grandparents will do this for their grandchildren. It can be an effective way to reduce the size of their estate, while making a real difference in the future of their grandchildren. Friends and other relatives are also free to contribute to these schemes.
There are a myriad of “qualified education expenses”
It is important to limit withdrawals to eligible expenses to avoid any taxes or penalties. For tuition, this includes tuition and fees, books, and other learning materials, including laptops and related equipment. A student’s room and board is another eligible expense, provided the student attends at least half-time. If housing is off-campus, the college will provide a “cost of attendance” figure to determine what portion of the housing cost is considered an eligible expense. Additionally, $10,000 per year can be used to pay K-12 tuition and a lifetime total of $10,000 can be applied to pay off a person’s student loans.
The remaining money can be used in other ways
If there is money left in a 529 that is not being used by the named student, the beneficiary can be replaced with another eligible family member. Funds can remain in the account indefinitely for potential education costs for the initial student or other family member later in life, including you. Unused funds can be distributed as a non-qualified withdrawal, but taxes and penalties generally apply on the earnings portion of the account.
Shawn Bumgardner is a financial advisor and president of Clear Horizon Wealth Advisors, a private wealth advisory firm of Ameriprise Financial Service Inc., Southgate. He can be reached at 734-284-3700.