College costs are rising fast. Planning ahead and saving is essential for parents who want their children to be able to go to college or university, and that comes with a ton of questions. Should you start saving before you child is born? Should you start saving as soon as your child is born? How early is too early, and how late is too late?
An increasingly popular savings tool is the 529 plan, a tax-free savings plan designed to help parents save up and pay for educational expenses. Did you know that you can start saving in a 529 before your child is even born?
Let's First Cover The Basics of 529 Plans
529 plans, sometimes called “Qualified Tuition Programs”, are tax-advantaged savings plans named after Section 529 of the Internal Revenue Code that are designed to help parents save and pay for the costs of education. They traditionally covered post-secondary education expenses, but with the passage of the Tax Cuts and Jobs Act of 2017 (TCJA) the funds can also cover up to $10,000 (as of 2019) in tuition for most forms of K-12 education.
529 Plans Have Two Important Benefits:
Some states offer state income tax credits or deductions for contributions
Funds in a 529 plan may be invested in the stock market and grow tax deferred, and are withdrawn tax free (there is no capital gains tax on withdrawal) if used for eligible educational expenses
529 Plans are one of the only types of investment vehicles that give you a tax benefit on the way in and the way out!
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There are two types of 529s: prepaid tuition and college savings plans
Prepaid Tuition Plans: These plans allow you to “lock-in” current tuition rates at participating colleges/universities and pay them off slowly over time, saving you from ballooning educational costs
Savings Plans: These are investment plans that grow savings and contributions over the long term. Any earnings and growth through a 529 plan are tax-free as long as they’re later used to pay for qualified educational expenses
Prepaid tuition plans often have more restrictions than savings plans. Prepaid plans may have residency and age requirements, restrictions on eligible expenses, and a limited list of participating institutions.
529 Plans Have Limits You Should Be Aware Of
Annual And Total Contribution Limits
There are no specified total contribution limits to 529 plans from the IRS, but the state plans themselves sometimes impose limits which are usually extremely high limits that most people don’t have to worry about. For example, New York’s 529 plan has a $520,000 limit for one beneficiary as of 2019.
Gift Tax Consequences
Contributions to 529 plans also count towards the annual $15,000 gift tax exclusion (as of 2019) from each donor to each donee. So two parents can give $30,000 to each child per year and the gift of those dollars will be tax free and free of any reporting obligations. A donor can contribute more than $15,000 to each recipient, but they will need to document it for the IRS with a Form 709 because it will be factored into the lifetime exclusion for your estate (currently $11.4M - so not something most people have to worry about).
Learn About Superfunding
Additionally, for 529 plans in 2019, the IRS allows you to make a large lump-sum contribution of up to $75,000 ($150,000 if married) in one year up-front and then “spread” those gifts over a 5-year period without incurring any gift tax reporting consequences (as long as no other contributions are made over that 5 year period that break the limit). This uses up five $15,000 gift tax exclusions at one time. This is often called “superfunding”. In order to do this, you would fill out a Form 709 to report your gifts. The benefit of doing this is that you may be able to get more tax free growth if you put in a larger principal balance earlier on. This is a great estate-planning strategy for grandparents who want to provide financial support for a grandchild’s education.
Do I Need To Be A US Citizen? No!
529 plans require the social security number of the account holder and the beneficiary but 529 plans are not restricted to only US citizens. All US taxpayers can open a 529 plan for a US citizen or resident alien. Beneficiaries must also be US Citizens or resident aliens. The account owner and the beneficiary can be the same person. Double check with your specific plan to understand their requirements about beneficiaries. A complete list of each plan’s policy about who can be an account holder can be found here.
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You Can Save In A 529 Before A Child Is Born - You Don’t Need Their Social Security Number
The holder of a 529 plan can switch the beneficiary with no penalty or gift tax consequences if they’re a qualified member of your family and the switch is between beneficiaries in the same generation (like a switch between siblings). Most plans limit you to one beneficiary change per year. If you want to set up a 529 plan before your child is born, put it in your own name or your spouse’s name and then switch it to your child later.
Beware The Gift Tax Consequences Of Changing The Beneficiary To Another Generation
Beneficiary changes don’t result in gift tax consequences if the change is to and from beneficiaries who are qualified family members in the same generation, like siblings.
In other cases, like the case of switching the beneficiary from parent to child, the switch may be considered a gift that needs to be accounted for on Form 709 if it exceeds the annual gift tax exemption ($15,000 per donor to donee in 2019). These beneficiary changes that are considered gifts likely won’t result in any actual gift taxes owed for most since the vast majority of people are and will remain below the lifetime gift tax exemption (in 2019, the limit is $11.4 million). But you may still have to complete Form 709 to report the beneficiary change - considered a gift - if it exceeds the exemption.
Keep in mind - lifetime exemption limits can change and could affect you in the future.
Don’t over save before a child is born!
Things might change! You might not have children and your child might not use or even need the saved funds.
The penalty for cashing out is steep at 10%, not to mention income taxes, so don’t put all your eggs in one basket that you might not even need. The penalties for cashing out for unqualified expenses are steep. You will pay a 10% penalty on your gains, you have to report those gains as taxable income, and you might have to pay back state income tax deductions that you had claimed while you held the 529.
529 Funds Can Be Used For Educational Expenses
Funds in a 529 plan can pay for tuition, room and board, laptops and other peripheral equipment”, school supplies, and any other expenses required for enrollment and attendance of an eligible educational institution.
Eligible Postsecondary Schools: Almost every accredited postsecondary institution is eligible and should be able to clarify that participates in aid programs from the Department of Education
Eligible Elementary or Secondary Schools: Any public, private, or religious school that provides K-12 education is eligible up to $10,000 per year (in 2019). However some states haven’t caught up with federal law so be sure to check on your state if you are planning to use a 529 for elementary or secondary school. Check out our article that addresses all the possible pitfalls: Should I Use A 529 Plan For Primary School Tuition?
The IRS provides a comprehensive list of eligible expenses in Publication 970, published each year.
When you withdraw money from your 529 to pay for qualified expenses, you have to report that on a Form 1099-Q.
What if my child isn’t bound for college or gets a substantial scholarship?
Even if the designated beneficiary doesn’t end up needing to funds, there are plenty of options for how to use the accumulated savings:
Use for primary school: With the passage of the TCJA, 529 plans can be used to pay for elementary and secondary school tuition
Change the beneficiary: You can change the beneficiary once per year to another sibling or family member who will need the funds, usually without penalty or tax consequences
Use for trade school: If your child is going to an accredited trade or vocational school, you can use the 529 plan to pay for that instead
Cash out with a penalty: You can cash out your 529 plan, but you will be subject to a 10% penalty and may be subject to additional income taxes unless you simply withdraw the principal and not the growth. There are exceptions that can cause the 10% penalty to be waived, but you will still be subject to income taxes on the gains. These exceptions are:
The beneficiary dies or becomes disabled
The beneficiary receives a tax-free scholarship
The beneficiary is attending a U.S. Military Academy
Remember: Changing the beneficiary between siblings does NOT result in any gift tax consequences. Otherwise, you might be subject to gift tax rules.
The First Thing To Do Is Check Your State’s Plan - But You Can Use Any State’s Plan
The National Association of State Treasurers has a comprehensive list of state 529 plans that you can use to find details about your state’s specific benefits. While your home state’s plan is often the best choice because of possible state income tax benefits, you aren’t restricted in your choice of 529 plan (unless a 529 has a specific residency requirement). You can choose any state’s 529 plan, and it might be helpful to shop around depending on your financial situation and wants for minimum/maximum contribution, administrative costs, and other differences in benefits.