Heritage Financial Planning

How Does a 529 Plan Work?

March 01, 2022

With higher education costs increasing, especially for private institutions, it’s always important to start saving for college. The 529 college saving plan is a financial option you might have heard about. If you've never heard of it and its intricacies, you'll want to stay tuned to learn how you can best leverage this savings plan and how it works. In this article we'll answer the following questions:

  1. What is a 529 plan?
  2. How can I open a 529 plan?
  3. Who maintains control over a 529 plan?
  4. How does a 529 plan work?
  5. How to choose a 529 plan
  6. What are qualified expenses for a 529 plan?
  7. Can you lose money in a 529 plan?
  8. 529 plan tax benefits
  9. What to do if you don’t end up using your 529 plan or the child doesn't go to college?
  10. Can I roll a 529 into a Roth IRA?
  11. What are the disadvantages of a 529 plan?

What is a 529 plan?

A 529 plan is a tax-advantaged savings plan designed to help pay for education. Initially, it was limited to post-secondary education expenses, but it was expanded to cater to K-12 education in 2017 and an apprenticeship program in 2019. The two major types of 529 plans are prepaid tuition plans and saving plans. Savings plans and withdrawals are non-taxable if used for qualified education costs. Prepaid tuition plans allow you to pay tuition at designated universities and colleges in advance.

How can I open a 529 plan?

A 529 plan can be opened directly with a state’s plan. Alternatively, many financial advisors and brokers offer a 529 plan where you can choose from various plans in your state.

Who maintains control over a 529 plan?

A 529 plan requires both an owner, who can be a parent or grandparent, and a beneficiary, who is typically the student. The owner has authority over the contribution amount, investment choices, and the timing and method of fund disbursement. Furthermore, the owner retains the ability to change the beneficiary of the 529 plan.

How does a 529 plan work?

A 529 plan has a beneficiary and an owner, but they can be the same individual. The owner chooses the beneficiaries, the investments, and determines when the withdrawals will be made. The owner is allowed to change beneficiaries without their approval. With that, there are various strategic options for a 529 plan that you can discuss with your financial professional.

How to choose a 529 plan

Almost every state has 529 plan savings, but you aren’t limited to choosing your home state’s plan. Each 529 savings plan offers an investment portfolio tailored to the account owners’ risk tolerance and time horizon. Your account might go up and down in value based on the performance of the investment options you choose. It’s important to consider your investment goals and compare your options before investing.

What are qualified expenses for a 529 plan?

Qualified expenses for a 529 plan include:

  • Special needs and accessibility equipment for students
  • The Internet, computer, and software used for schoolwork
  • Meal plans and campus food
  • Off-campus housing
  • Student loan repayments
  • Books and school supplies
  • Elementary and K-12 tuition and fees
  • College, graduate, and vocational school fees

Can you lose money in a 529 plan?

While you will not lose unused funds, it’s essential to understand that most 529 plan investment options entail market risks and investing in bonds and equities. For a risk-averse investor, many 529 college plans offer FDIC-insured account options with lower risks and lower returns.

529 plan tax benefits

A 529 college savings plan works like a Roth IRA or Roth 401(k) by investing your after-tax contributions in ETFs, mutual funds, and other similar investments. Your investment grows on tax-deferred terms, and the withdrawals are tax-free if the funds are meant to pay for qualified higher education expenses. Also, contributions aren’t deducted from federal income taxes.  

You might also qualify for a state tax benefit based on your state of residence. More than 25 states offer state tax credits and state income tax deductions for 529 plan contributions. These tax benefits make 529 plan savings plan the best educational savings cost account than investment or traditional savings. 

Some families use a 529 plan savings plan like an estate-planning vehicle because contributions are a complete gift to the beneficiary. Up to $15 000 per donor, per beneficiary, are eligible for the annual gifts tax exclusion.

Note: Because Texas does not have a state income tax, tax advantages are not applicable in the state. 

What to do if you don’t end up using your 529 plan or the child doesn't go to college?

If your child doesn’t end up using all their 529 savings to cover their education expenses, you have a few options.

First, you can transfer the balance to another child or use it yourself for qualified educational expenses. To do this, you’ll have to change the beneficiary on the account. Your 529 college plan savings broker has guidelines on how to do it.

Otherwise, you can withdraw the funds, though you have to pay a 10% penalty and other income taxes you might incur. You might also roll it over to your relative’s ABLE accounts without incurring any costs. These tax-deferred accounts are designed for disabled people receiving Social Security insurance benefits before turning 26.

Can I roll a 529 into a Roth IRA?

No, you cannot directly roll a 529 plan into a Roth IRA. Roth IRAs and 529 plans are separate types of accounts with different tax implications and purposes.

A 529 plan is a tax-advantaged savings plan designed specifically for educational expenses, while a Roth IRA is an individual retirement account that is used for retirement savings and has its own contribution limits and withdrawal rules.

However, it's worth noting that if you have leftover funds in a 529 plan after the beneficiary has completed their education, you may be able to change the beneficiary to another eligible family member, including yourself or your spouse, and use the funds for their educational expenses. Alternatively, you could choose to take a non-qualified withdrawal from the 529 plan, but that may be subject to taxes and penalties on the earnings portion of the withdrawal. If you're considering transferring funds from a 529 plan to a Roth IRA, it's important to consult with a qualified financial advisor or tax professional to understand the potential tax implications and limitations of such a move.

What are the disadvantages of a 529 plan?

Three potential disadvantages of a 529 plan include:

  1. Limited investment options: 529 plans typically offer a limited range of investment options, which may not align with the owner's investment preferences or risk tolerance. This can result in less flexibility and diversity in the investment portfolio.

  2. Penalty for non-qualified withdrawals: If funds from a 529 plan are used for non-qualified expenses, such as non-educational expenses, they may be subject to federal income tax and a 10% penalty on earnings. This can reduce the overall value of the plan and limit its intended use.

  3. Impact on financial aid eligibility: Assets held in a 529 plan are considered parental assets for the purposes of calculating financial aid eligibility, which means they may impact the student's eligibility for need-based financial aid. This could potentially reduce the amount of financial aid the student may receive.

Bottom line                        

A 529 plan is essential for parents who value a college education and desire to save money while making financial contributions. These benefits are too good to ignore. Contributions grow tax-free funds, and withdrawals for qualified education expenses are not taxable. Contact our team for guidance regarding college planning

Written By: Heritage Financial Planning Team

What Is Fee-Only Financial Planning?

Managing your finances effectively and making informed financial decisions is a critical aspect of securing your future financial well-being. To navigate this complex landscape, many people turn to...

Read More

What is a Lump Sum Distribution?

Managing your personal finances is very important. For those that budget, save, and invest strategically, there will eventually come a time when they want to start taking withdrawals from their...

Read More

Do I Need Life Insurance?

Life is full of uncertainties, and it is always challenging to determine if you are protected for the future. Macroeconomic conditions, family dynamics, financial goals, and succession planning are...

Read More

10440 N Central Expressway
Suite 1540
Dallas, TX 75231