At some point, most new parents or grandparents begin thinking about how to pay for college. Since educational costs have risen at a rate well in excess of inflation over the last two decades, covering the cost of college is no mean feat. Fortunately, 529 plans offer parents and grandparents a tax-advantaged vehicle to save for and fund college expenses.
529 plans were established in 1996 under section 529 of the Internal Revenue Code, and they offer a few tax advantages as follows:
- Although there is no federal deduction for 529 contributions, some states offer tax deductions for 529 plan contributions. Georgia allows a deduction of up to $2,000 per beneficiary if you file individually and $4,000 if you file taxes jointly. Generally, the income tax rate in Georgia is 6%, so the maximum deduction can save parents a few hundred dollars per year for each child.
- Growth within the 529 plan is not taxed. Thus, there is no tax on capital gains or interest and dividends, and over the longer term, avoiding this tax drag contributes a good bit to long-term growth of the account.
- As long as fund proceeds are used for qualified educational expenses, there is no tax on withdrawal.
- If funds withdrawn aren’t used for qualified expenses, the amount of the withdrawal attributable to earnings is taxed and a 10% penalty is levied on the earnings as well.
The structure of 529 plans is relatively straightforward, and the accounts include both an owner and a beneficiary. The beneficiary, as the name implies, is the person for whom the funds will be used and it’s important to note that the beneficiary on a 529 plan can be changed to other qualified family members. The definition of qualified family members is fairly broad, so that helps reduce the possibility that the funds will either go unused or be withdrawn for non-qualified expenses and thus subject to both tax and a penalty.
Most states offer 529 plans, and the official Georgia plan is the Path2College plan administered by TIAA CREF. Although state plans were relatively restrictive at one time, they’ve become much more open. Most plans allow residents of any state to participate, and can also be used to fund college outside the state in which the plan is offered.
There are a few additional key points to bear in mind if you’re considering or are already contributing to a 529 plan. They are:
- Reimbursing yourself in the same year – if you are paying for qualified expenses out-of-pocket and using the 529 plan to reimburse yourself, make sure you do it in the same year in which the expenses were incurred. Expenses incurred in previous years aren’t considered qualified, and thus the reimbursement can be subject to both taxation and a 10% penalty.
- If your child earns a scholarship, you can withdraw funds from the 529 up to the amount of the scholarship. You’ll have to pay tax on earnings, but the 10% penalty on earnings is waived.
- 529 plans that are owned by the parent or the dependent student are included as an asset when calculating eligibility for financial aid.
529 plans provide some clear advantages when it comes to saving for college1. Nevertheless, make sure you understand the rules surrounding these plans to ensure they’re right for you and you take full advantage of the tax savings they can offer.
- Recent legislative changes now allow 529 plans to be used to fund K-12 private school expenses as well. ↩