Pros and Cons of 529 Plans in College Savings and Tax Breaks

Given the notoriously high cost of education in the US, parents, parents-to-be, or anyone planning to pay for college would be wise to start thinking about saving as early as possible.

And what better time than 529 College Savings Day to start thinking about a college savings account? The so-called “holiday” is celebrated on 29 May to bring awareness about the 529 schemes. Officially known under the tax code as Qualified Tuition Programs, 529 plans are tax-advantaged education savings accounts that are independently sponsored and run by nearly all 50 states and the District of Columbia.

The plans have grown in popularity over the years, with an estimated 16 million accounts with an average balance of $25,630 by the end of 2022, up from about 13 million accounts in 2017, according to the College Savings Plans Network (CSPN).

Anyone can open a 529 plan and contribute to a designated beneficiary, and earnings and withdrawals are federal income tax-free as long as the money is used on qualified education expenses.

But those aren’t all the benefits — here’s a look at the pros and cons of 529 plans, and how to decide whether one is right for you.

In the past, families could only use money from their 529 plans to pay for college, but the list of eligible expenses has grown over the years.

Here are some other qualified expenses to consider using 529 funds.

Educational costs from kindergarten through college

Some families elect to use 529 funds before their children reach college age because you can use up to $10,000 per year to pay for kindergarten through 12th grade tuition at private schools.

Unlike college costs, however, your 529 plan funds can only go toward tuition for elementary and high school. When your beneficiaries go to college, however, they can spend the 529 money on tuition and expenses such as room and board, textbooks, computers and more.

You can also put a total of $10,000 from 529 plans toward student loan payments for the beneficiary or their siblings. There is a lifetime limit of $10,000 per borrower, so even if multiple parties open multiple 529 plans for the same beneficiary, the total amount that can go toward student loan repayment for that beneficiary is still $10,000.

However, funds from a single 529 plan can go toward loan repayment for the beneficiary and their sibling, as long as the amount does not exceed $10,000 per borrower.

trade school and apprenticeship expenses

If your child or beneficiary decides to take a career path other than college, their 529 plan may still come in handy. Funds can be used to cover tuition and expenses, including textbooks, supplies, equipment and fees, for qualifying trade schools and apprenticeship programs.

Roth IRA Rollover

Beginning in 2024, thanks to the SAFE 2.0 Act passed in December 2022, beneficiaries will have the option of rolling some 529 plan funds tax- and penalty-free into a Roth Individual Retirement Account (IRA).

The 529 plan must be at least 15 years old and rollover funds will still be subject to the Roth annual contribution limit, which is $6,500 for 2023. People 50 and older can contribute an additional $1,000. Beneficiaries can roll over up to $35,000 over their lifetime.

Setting aside your money for something specific, such as education, can help motivate you to save. But the tax advantages are the main reason 529 plans differ from regular savings accounts.

On top of tax-free growth, some states allow taxpayers to deduct or receive a credit for 529 plan contributions on their taxes.

“For people who are earning a decent salary, eliminating some state tax is beneficial,” Michael Green, a certified financial planner with a background in college and independent school financial aid, tells CNBC Make It. “Putting money in a 529 is a win-win on many levels.”

You can certainly keep the money in a regular high-yield savings account for future education expenses, but you won’t get any tax benefits.

“There’s a lot of opportunity and flexibility within [529 plans] Rachel Bayer, president of CSPN and assistant state treasurer for the state of Nebraska, told CNBC Make It that other thrift vehicles may not allow that.

However, people sometimes misunderstand that flexibility, Bayer says. Contrary to popular belief, you can invest in any state-sponsored plan and you are not required to send your beneficiary to college in the state that sponsors the plan.

But you’ll only get the state tax deduction if you use a plan from the state where you live, so it’s a good idea to compare your options.

Additionally, you can change the beneficiary on your 529 plan as many times as you like, as long as the new recipient is a qualifying relative – which includes the original beneficiary’s siblings, spouses, first cousins, children and more.

One of the main drawbacks of saving in a 529 plan is that you are subject to a penalty if you use the funds for nonqualified expenses. If you need to withdraw the money or use it for non-education-related expenses, you’ll owe a 10% penalty and taxes on any investment gains.

Additionally, when using plans to save for college, there is a widespread view that 529 plans can hurt your child’s chances of receiving financial aid. “Although there is a small effect, it is not significant,” says Bayer.

The Free Application for Federal Student Aid (FAFSA) takes 529 plan savings into account, but not at face value, when determining your expected family contribution (EFC).

A parent’s assets — which includes all funds in 529 plans owned by dependent students or custodial parents for FAFSA purposes — are assessed up to 5.64% when applying for financial aid for their child. This means that if a student has a 529 plan with $10,000 in savings when they file their FAFSA, their household’s EFC can increase to a maximum of $564.

Another consideration some parents consider is what if their child doesn’t want to go to college or if they earn a full scholarship. A 529 plan can still be beneficial because it can be used to pay for other costs such as books and supplies that may not be covered by scholarships or financial aid.

Alternatively, the beneficiary will have the option of getting a head start on retirement savings by transferring those funds to a Roth IRA.

If you’re planning to pay for an education in the future — for your child, your niece or nephew, a godchild or yourself — a 529 plan may be a good place to invest.

“You get the potential for a tax deduction on your state taxes, you’re allocating money to a specific goal that’s important to you, you’re putting it in an environment where it can grow without the tax and [withdrawals are] Tax-free if you’re using it for educational expenses,” Greene says.

However, parents may be tempted to prioritize their child’s college funds over their own needs, which Green advises against.

“If you save all your discretionary money in a 529K, you don’t have money to handle emergencies,” he says. “There is no point in putting money into an account that you will be penalized for withdrawing from.”

But even if you can’t afford to put away the cash value of entire college tuition, every little bit helps, especially if you invest consistently over time.

“There’s never too little to save, especially if you start saving early,” Green says. “If you open a 529 the month your newborn comes home and put in $10 a month, $100, or whatever you can afford, you’ll have more saved for college and you’ll You won’t have to put in as much effort as time and compound interest will be on your side.”

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