• College Planning

When Does a 529 Plan Make Sense for College Planning?

September 24, 2018 | Amin Dabit, CFP®

Since they were first established in 1996, Section 529 savings plans have become a popular tool used by parents to save for future college expenses. One reason 529 plans are so popular is the tax breaks they allow. As long as funds are used to pay for qualified education expenses, earnings within the account grow tax free. Also, many states allow full or partial deductions for 529 plan contributions.

What is a 529 Plan?

A 529 plan is a state-sponsored, tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” can also be sponsored by state agencies or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

There are numerous investment options in a 529 plan account and if your child receives a scholarship, you can withdraw the scholarship amount penalty-fee and transfer the funds to another beneficiary.

Adversely, if you take out money from your 529 plan account to use for non-education expenses, you’ll incur federal income tax and an additional 10% penalty on the gains. You’ll also pay applicable state taxes if you received a deduction for your contributions.

Take Our Quiz: How Do Your Education Savings Stack Up Against the Average American?

529 Plans and Tax Reform

529 plans got a boost from the tax reform that was signed into law in December 2017, which includes a provision that allows 529 plan funds to be used to pay for qualifying elementary and secondary school expenses, as well as college expenses, without paying a penalty or taxes.

Before the tax reform legislation, any 529 plan withdrawals that were not used to pay for qualified college education expenses were subject to ordinary income tax and a 10% tax penalty on the earnings portion of the distribution. Now, up to $10,000 of 529 funds can be withdrawn per child each year to help cover primary and secondary private school tuition.

Note: federal rules are allowing qualifying K-12 expenses with 529 plans, but it doesn’t necessarily mean a plan sponsored by your state or educational institutions has adopted the same rules. You’ll likely want to consult a professional to ensure if the state-sponsored 529 plan you have conforms to the new rules before taking a distribution.

Who Should Use a 529 Plan?

529 plans are primarily geared toward families who are fairly certain the beneficiary will attend college. Most plans offer valuable tax benefits and can be an attractive option for more “hands-off” investors (assuming an aged-based option is available). But there are tradeoffs. Here are some items to look out for and be aware of:

  • High fees. College savings plans sold through a broker may be loaded with commissions and fees, just like any other investment product. If fees are high, the tax benefits could fade relative to purchasing low-cost ETFs elsewhere.
  • Minimal control over the investment strategy. According to the IRS rules, you can only adjust your 529 plan investments twice a calendar year. Depending on the 529, you may be limited to a small amount of investment options to choose from.
  • Minimizes your child’s financial aid eligibility. 529 plans count as an available asset when the federal government and colleges calculate financial aid.
  • Living in a no-income tax state. If you live in a state that provides a 529 deduction, choosing a plan in your state likely makes sense. If not, costs matter.

Front Loading Your 529 Plan

High-income earners (or people with a large enough estate) can put up to five years of the annual gift exemption into their children’s 529 accounts without gift tax issues.

  • Pros: When you front-load your 529 plan, your earnings will be compounded on more money over a longer time period. This means the more you put in initially, the longer that money has to grow and the greater the balance when it’s time to pay tuition. For example, you can contribute $75,000 (or $150,000 if you gift-split) into the 529 while your child is young to enjoy more years of investment growth and compounding. There is a true benefit in the ability to open a 529 plan, front load it and, at the same time, eliminate that amount from potential estate taxes. It’s also a very good use for a big bonus or inheritance.
  • Cons: With rising costs of college, it may seem very difficult to overfund a 529 plan, but it does happen. As a reminder, for your funds to be withdrawn tax-free, the money must only be used toward qualified educational expenses. If you’re concerned about overfunding, you may want to try funding only your child’s first two years of college and use other taxable accounts or loans to fund the final years.

What to Do if You Overfund Your 529 Plan

Remember: many children will get scholarships, decide to go to community college for at least one year or decide not to go to college altogether. The more children you have, the greater chance at least one will not require a full four-year university. If your child gets a scholarship, you can pull the equal amount out without penalty.

Also, thanks to tax reform, you may also use the money for qualified expenses if you have younger children who can benefit from the funds in primary and secondary school. However, if you don’t have use for the funds in that manner, money can be transferred to another qualified beneficiary to be used for education. Qualified beneficiaries include immediate family members, relatives of your immediate family (e.g. nieces, uncles, etc.), in-laws, and first cousins.

Keep in mind, a 10% penalty and ordinary income tax are charged on investment gains for non-qualified distributions. There is no penalty or taxes on principal – you would only pay a penalty on gains that you have deferred for a long period of time.

Our Take

529 plans are helpful and appropriate in most situations. But in some cases, there can be other ways to invest that don’t have as much of a reduction to financial aid, limit investment flexibility. Consider your situation and goals to best determine which approach makes sense for you. Overall if you choose the right 529 it can bring significant tax benefits and allows for a lot of flexibility if you need to adjust beneficiaries.

To learn more, read our free Personal Capital Guide to Saving for a Child’s Education.

Read the Free Guide


Disclaimer: The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. No part of this blog, nor the links contained therein is a solicitation or offer to sell securities. Third party data is obtained from sources believed to be reliable; however, Personal Capital cannot guarantee the accuracy, timeliness, completeness or fitness of this data for any particular purpose. Third party links are provided solely as a convenience and do not imply an affiliation, endorsement or approval by Personal Capital of the contents on such third party websites. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Get Started



Get to know your money

"APP STORE STAFF PICK" – ITUNES