The 529 Savings Plan
529 Savings Plans work like a Roth IRA for education savings. Owners can establish accounts for beneficiaries that are funded with after-tax dollars, but grow completely tax-free assuming the withdrawals are used for qualified education expenses.
The cost of post-secondary education in the United States has been steadily increasing at a rate of 6.2% annually for the last 20 years.
Average inflation during that same span? 2.64%
I recall a conversation I had with a couple of co-workers a few years ago who had multiple children in college.
Their advice was simple and clear: “Save now!”
At the time, our oldest child was 2 or 3 and our daughter would have been an infant if she was even born at the time.
Fortunately, we had already begun saving for our kid’s education in a 529 Education Savings Plan.
In this post, we’ll get into the nitty gritty of these accounts and try to explain why you should or shouldn’t use them.
How 529s Work
Put simply, a 529 Savings Plan is like a Roth IRA for education.
Account owners designate a beneficiary for savings and all deposits are made with after-tax dollars.
The funds in the account can be invested a variety of ways which we’ll talk about in a bit, but distributions taken out and used that same calendar year for a qualified education expense are completely tax-free.
Not only that, but in many cases, if the account owner uses the 529 savings plan sponsored by their state, they can receive a deduction for their contributions from their state income tax return (if applicable).
The combination of tax-free growth and a potential state income tax deduction make 529 savings plans an attractive saving vehicle for future education expenses.
Features
Initially, 529 savings plans were only available for college education expenses, but in 2018 the SECURE Act expanded the use of 529s to K-12 tuition expenses, trade schools or some other types of training, and student loan repayment.
There aren’t any federal contribution limits to 529 savings plans, but they are subject to the Gift Tax Exclusion…eventually. You see, the federal government allows anyone to contribute to 529 savings plans up to the Gift Tax Exclusion for up to five years in advance.
For example, in 2022 the annual Gift Tax Exclusion amount is $16,000 per giver per recipient. This means one could contribute up to $80,000 ($16,000 x 5) in one year to a single beneficiary’s 529 savings plan.
However, front-loading contributions in this way would mean no further cash gifts or contributions could be made to or for the benefit of that same beneficiary until after the end of the 5th tax year.
States sponsor their own 529 savings plans and each state has its own rules for how much one can contribute in a given year or even for the whole account total. All plans have a cap on contributions at some point. In 2022 it ranged from $235,000 to $550,000 depending on the state.
Once an account reaches this cap, it can continue to grow, but no further contributions can be made.
States also have varying maximums on income tax deductions ranging from $0 to $30,000 depending on your filing status, income, and the state you live in. Here’s a table for your reference:
Alabama | $5,000 single / $10,000 joint beneficiary |
Alaska | No state income tax |
Arizona | $2,000 single or head of household / $4,000 joint (any state plan) beneficiary |
Arkansas | $5,000 single / $10,000 joint beneficiary |
California | None |
Colorado | Full amount of contribution |
Connecticut | $5,000 single / $10,000 joint beneficiary, 5-year carry-forward on excess contributions |
Delaware | None |
Florida | No state income tax |
Georgia | $4,000 single / $8,000 joint beneficiary |
Hawaii | None |
Idaho | $6,000 single / $12,000 joint beneficiary |
Illinois | $10,000 single / $20,000 joint beneficiary |
Indiana | 20% tax credit on contributions up to $5,000 ($1,000 max credit) |
Iowa | $3,439 single / $6,878 joint beneficiary |
Kansas | $3,000 single / $6,000 joint beneficiary (any state plan), above the line exclusion from income |
Kentucky | None |
Louisiana | $2,400 single / $4,800 joint beneficiary, unlimited carry-forward of unused deduction into subsequent years |
Maine | None |
Maryland | $2,500 single / $5,000 joint beneficiary, 10-year carryforward |
Massachusetts | $1,000 single / $2,000 joint beneficiary |
Michigan | $5,000 single / $10,000 joint beneficiary |
Minnesota | $1,500 single / $3,000 joint beneficiary |
Mississippi | $10,000 single / $20,000 joint beneficiary |
Missouri | $8,000 single / $16,000 joint beneficiary |
Montana | $3,000 single / $6,000 joint beneficiary |
Nebraska | $10,000 ($5,000 for married taxpayers filing separate returns) |
Nevada | No state income tax |
New Hampshire | No state income tax |
New Jersey | None |
New Mexico | Full amount of contribution |
New York | $5,000 single / $10,000 joint beneficiary |
North Carolina | None |
North Dakota | $5,000 single / $10,000 joint beneficiary |
Ohio | $4,000 single / $4,000 joint beneficiary, unlimited carry-forward of excess contributions |
Oklahoma | $10,000 single / $20,000 joint beneficiary annually, five-year carry-forward of excess contributions |
Oregon | $150 single / $300 joint beneficiary up to $30,000 income, higher income lowers % of deduction |
Pennsylvania | $15,000 single / $30,000 joint beneficiary |
Rhode Island | $500 single / $1,000 joint, beneficiary, unlimited carry-forward of excess contributions |
South Carolina | Full amount of contribution |
South Dakota | No state income tax |
Tennessee | No state income tax |
Texas | No state income tax |
Utah | 5% tax credit on contributions of up to $2,040 single / $4,080 joint beneficiary (max credit of $102 single / $204) |
Vermont | 10% tax credit on up to $2,500 single / $5,000 joint beneficiary (max $250 tax credit per taxpayer, per beneficiary) |
Virginia | $2,000 single / $2,000 joint beneficiary, full contribution for taxpayers over 70, unlimited carry-forward of excess contributions |
Washington, DC | $4,000 single / $8,000 joint beneficiary |
Washington | No state income tax |
West Virginia | Full amount of contribution |
Wisconsin | $3,340 single / $3,340 joint beneficiary |
Wyoming | No state income tax |
Flexibility
While limiting tax benefits to education expenses can be a drawback, there is some flexibility if things don’t pan out the way you plan.
First, the account beneficiary can be changed from the original beneficiary to his or her:
- spouse, son, daughter, stepchild, foster child, adopted child, adopted child, or any of their descendants;
- brother, sister, stepbrother, or step-sister;
- father or mother or ancestor of either;
- stepfather or stepmother;
- nieces, nephews, aunts, or uncles;
- son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law;
- the spouse of anyone listed above;
- and finally, any first cousin.
This could prove useful if you end up over-saving for your beneficiary’s education and would like to redirect the money instead of taking a withdrawal penalty for pulling out the balance.
The IRS also allows you to withdraw funds from the account without penalty to match any scholarships the beneficiary receives, if they are admitted to a military academy, or if the beneficiary becomes disabled or passes away.
In any of these cases, you would owe capital gains taxes on any long-term gains and income tax on any short-term gains for the tax year in which the withdrawal is made.
An easy way to turn those short-term income taxes into long-term gains is to just wait a year to make the withdrawal.
Limitations
One of the most obvious limitations to 529 savings plans is the requirement that they are used for qualified education expenses.
Unqualified withdrawals of account earnings (not contributions) are subject to a 10% penalty.
Obviously, subjecting your account to this penalty would defeat the purpose of using a 529 savings plan in the first place.
This reason alone is deterrent enough for many people who avoid 529 savings plans altogether.
Having a 529 savings plan also impacts your FAFSA eligibility.
Plans owned by a parent or the dependent student are considered a parental asset on the FAFSA (Free Application for Federal Student Aid). Around $10,000 will fall under the Asset Protection Allowance and any amount exceeding that will reduce a student’s potential aid offering by up to 5.64% of the asset’s value.
For example, if you have $50,000 in parental assets, the financial aid package would be reduced by $2,256 ($50k – $10k x 5.64%).
529 savings plan assets owned by a grandparent (or another relative) are not included in the FAFSA application, but withdrawals from the 529 will be treated as income for the student in subsequent years. This could dramatically decrease aid amounts, so proceed carefully with this approach.
Finally, many people from states that don’t provide an income tax deduction would consider the absence of any such deduction as a considerable con to using a 529 savings plan.
I agree with this, but I wouldn’t totally discard them based on this circumstance alone. If you begin savings far in advance, the tax-free growth is a huge opportunity that you can’t really achieve elsewhere without siphoning from your own retirement.
Alternatives
We’re not going to spend a lot of time here, but there are alternatives to 529 savings plans one can consider for education savings. We cover these with more depth at Milestone 7 of the Next Dollar Roadmap.
Coverdell Education Savings Accounts have declined in popularity over the years because they are even more restrictive than 529 savings plans. The only advantage I know of for Coverdell’s over 529s is they provide more control to the account owner over the investments in the account.
Many people use their Roth IRAs to pay for education expenses since such withdrawals are permitted without penalty. I’m not a big fan of this myself because one’s retirement should be prioritized over anyone’s education expenses.
There are two primary reasons for this.
First, there are a lot of people loaning money for school, but I’ve never heard of a retirement loan. If you use up your Roth IRA for little Susie’s education, good luck finding a way to replace it after you’ve retired.
Second, your kids would rather borrow money for school than have you living in their basement as you age. Save that Roth for yourself. Your kids can thank you later.
Next, UGMA or UTMA accounts are tax-advantaged options, but they have limitations of their own.
Finally, you can just skip all tax-efficient methods and just cashflow college expenses out of your pocket.
Our Strategy
It’s impossible to know how much you will need to save for post-secondary education expenses when you need to start saving for those expenses.
The dollars saved earliest in your little beneficiary’s life will have the maximum opportunity if saved as soon as they get a social security number (or earlier if you plan to transfer the savings later).
But what if they decide not to go to college or don’t have the grades to get in?
What if you save for public, in-state tuition, but they decide to study across the country or go to a private school?
It’s folly to try and account for everything. You’ll just have to do the best you can.
We watch the annual cost of attendance for public schools in our state and are aiming to land the 529 plane at 80%-90% of that cost. The balance we’ll either let our kids pick up or we can cashflow ourselves.
We also haven’t told them we’re saving because we don’t want to sap their motivation for academic achievement.
But that’s just our strategy. Like most things financial, this is a personal decision.
I’ve known ultra-wealthy people who refused to contribute a single dollar to their kid’s education (believing the kid would value it more if they had to work for it themselves), and I’ve known people who struggled to pay every cent for their child even if it came at their own personal expense.
Regardless, it will pay dividends down the road to start thinking about how you want to approach this now.
If you need more convincing, read our post on the student loan dichotomy. Perhaps it will motivate you to try and spare your student from as much education-induced financial suffering as possible.
Legacy Saving
One final strategy involving 529s is long-term legacy saving.
Because 529 savings plans allow assets to be transferred to a long list of people (see above), with thoughtful planning one could establish a sort of endowment for a beneficiary or beneficiaries and many of their descendants for years to come.
The account owner can also be changed or even transferred as an inheritance to someone else.
The rules do vary depending on the plan and there are some tax hurdles to navigate, but if you have the means and the desire to save for the education of future generations, this can be a great way to do it.
Instead of a lengthy explanation, I’m going to link you to one of the best sources I’ve found on the topic: Kitces.com’s Using A Family Dynasty 529 Plan For Multigenerational College Planning.
