Maximize Your 529 Plan Potential: Benefits and Limitations

Each year, on May 29th, we celebrate National 529 Plan Day. It serves as a reminder, for parents and others, to save for children’s future educational needs. 529 plans are the most popular type of education savings account. They’re tax-advantaged when used for qualified educational expenses.

In honor of the day, I’m providing information to help you understand the benefits and limitations of 529 plans, so that you can maximize their potential and tailer them to your family’s specific educational needs.

You may be able to claim state tax deductions by using a 529 Plan to pay for a child who’s already in college, simply by putting the money into the savings account first, rather than paying the institution directly.

The Growing Cost of Education

Although it wasn’t always the case, paying educational costs for children is currently one of the highest priorities for many parents. This makes sense, given the significant correlation between level of education and lifetime earnings and the high cost of college.

According to the Education Data Initiative,
the average annual college tuition went up:

12% between 2010 and 2019
6% between 2000 and 2009
7% between 1990 and 1999
7% between 1980 and 1989
9% between 1970 and 1979

The article, How Much Will You Need to Send Your Child to College in 2030?, published by U.S. News & World Report, noted that if tuition continues at its current pace, “by 2030, annual public tuition will be $44,047. The total cost for a four-year degree will be more than $205,000.” Tuition rates (in contrast to many other expenses) tend to increase the most during the worst economic times, when schools are seeking ways to make up for losses from cuts in state funding.

Tuition inflation statistics don’t necessarily account for, or reflect, the total cost of an education. In addition to tuition, many schools now have multiple-year residency requirements. Additionally, the expenses associated with transportation, books, and other supplies have increased substantially. Unfortunately, for students and parents who want to help them pay for their education, most investments won’t earn enough to keep pace with these rapidly rising costs.

Parents typically fund college through some combination of 529 plans, savings, federal aid, student loans, and Coverdell Educational Savings Accounts.

An Overview of 529 Plans

(Section) 529 plans, also called Qualified Tuition Programs or QTPs, are investment accounts that offer tax-free withdrawals for funds that are used to pay for qualified education expenses. 529 plans were named after the section of the Internal Revenue Code (IRC) where they’re described.

Owner’s use 529 plans to pay for tuition at colleges, universities, and even some apprenticeship programs. Funds can also be used for federal student loan repayment. The IRC outlines the requirements a plan must meet to receive federal tax advantages and exemptions.

Although contributions cannot be deducted from federal taxes, earnings grow tax-free. And, so long as they’re for qualified educational expenses, withdrawals aren’t taxed either.

Contributions aren’t strictly for parents. Anyone over 18 can open a 529 plan account, and anyone can contribute to an existing 529 plan account. That’s handy, in case you want to crowdfund your kid’s education.

There are more than 100 different 529 plans that cater to various education paths and/or needs, which all fall into two distinct types:
prepaid tuition and educational savings.

Educational Savings Plans

States sponsor 529 educational savings plans. They can be purchased outside of one’s state of residence. Although all states offer 529 plans, not all plans are equivalent. Some separate two and four-year schools. A few split tuition costs and room and board into two distinct plans.

There are currently 30 states that offer tax incentives to residents who contribute to an in-state 529 plan. Nine states are parity states – their residents can deduct contributions to any 529 plan, whether it’s created in-state or not.

They are:

Arizona
Arkansas
Kansas
Maine
Minnesota
Missouri
Montana
Ohio
Pennsylvania

A 529 account in a parent’s name is counted in FAFSA calculations, which may reduce that student’s eligibility for federal aid, whereas a 529 plan in a grandparent’s (or other relative’s) name won’t.

Prepaid Tuition Plans

The Michigan Educational Trust, created in 1986, was the first 529 prepaid tuition plan. Owners purchase credits now and use them to pay tuition later. One difference between 529 savings plans and prepaid tuition plans is that they’re exclusively for tuition.

In other words, students can’t use the funds to pay for books, room and board, or other expenses. Some states guarantee that an account, if funded to a certain amount by a certain date, will cover the full cost of an undergraduate degree. If the account falls short of future costs, they’ll waive the difference.

Although families usually assume that prepaid tuition plans are all “locking in” current prices, a premium is sometimes added to the going rate.

Because of the rapid increase in tuition costs, over time, most states are no longer letting investors open new 529 prepaid tuition plans. The number of states offering them has dropped from twenty-two to nine.

Those remaining states are:

Florida
Maryland
Massachusetts
Michigan
Mississippi
Nevada
Pennsylvania
Texas
Washington

Some states have frozen existing accounts to block additional credit purchases.

Private College 529 Plans

Stanford, Princeton, MIT, and Emory are among the more than 300 institutions that accept funding from Private College 529 plans. Tuition credits are good for up to 30 years. Note that private universities don’t give preferential treatment in admission decisions to students with these types of accounts.

Unused Prepaid Tuition Plan Funds

What happens when a student with a 529 prepaid tuition plan does not choose a school covered by the plan? Most states will return the initial contributions (after fees). Some will also return the investment earnings.

Another option that may be available, depending on state rules and regulations, is a balance transfer to another 529 plan account with a different beneficiary (typically a younger sibling).

Qualified Institutions & Expenses

According to the IRS “An eligible educational institution is a school offering higher education beyond high school. It is any college, university, trade school, or other post-secondary educational institution eligible to participate in a student aid program run by the U.S. Department of Education.”

To check specific schools, visit the U.S. Department of Education’s Database of Accredited Post Secondary Institutions and Programs (DAPIP) or the Federal Student Loan Program list.

The American Recovery and Reinvestment Act (ARRA), passed in 2009, added computers, printers, and certain software to the list of qualified educational expenses.

The Tax Cuts and Jobs Act (TCJA), of 2017, allows for $10,000 per year, from an educational account, to be used for tuition at both public and private K-12 schools. Be sure to verify how your state handles taxes on withdrawals for elementary educational expenses.

Since the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, fees, books, supplies, equipment for registered apprentice programs, and loan repayments are qualified.

You can find a complete breakdown of what constitutes a qualified expense at Exempt Organizations Technical Guide (p. 8-9).

Qualified higher education expenses include:

Tuition, fees, books, supplies, and equipment
(needed to enroll in or attend an eligible educational institution).
Potentially, room and board expenses for eligible students
(stipulations may include degree seeking, more than half-time, maximum allowance, etc).
Special needs services expenses.
Technology, including computers, software, and/or internet
(primarily used for education).

529 Plan Contribution Limitations & Considerations

529 plan contribution limits (both minimums and maximums) vary from state to state. A key factor that influences contribution amounts is the annual gift tax exclusion ($18,000 for 2024).

Special 529 plan rules allow for a lump sum contribution. Someone could add $95,000 in funding to an account this year.
(five times the annual gift tax exclusion for 2025)

STARTING THIS YEAR – Roth Rollovers!

Parents, rightfully, have been concerned with what will happen to 529 savings plan contributions if their children do not need money for education. What will happen if their child receives a scholarship, uses GI Bill benefits, or goes into a field that doesn’t require formal education?

Financial planning can be difficult because, to some degree, it requires we attempt to predict the future. And futures have a habit of shifting midstream. Fortunately, beginning in 2024, unused money in a 529 plan can be rolled over into a Roth.

There are (of course) a few stipulations:

The 529 plan beneficiary must be the owner of the Roth IRA.
The maximum amount that can be rolled over is $35,000.
529 plans must be opened at least 15 years prior to the first rollover.
Rollovers can’t exceed annual contribution limits ($7,000 in 2024).
Beneficiaries can’t roll over more than their earned income that year.

Make A Wise Investment

It’s wonderful that there are so many products out there to help us build wealth and achieve our long-term goals, but the shear magnitude of our options can create decision paralysis. Deciding what to do with our financial resources can easily become overwhelming.

Hopefully, this article cleared up a few things about section 529 plan accounts and provided the information you need to move forward. It’s vital to start early, and maximize your educational savings strategy, because:

An investment in knowledge pays the best interest.
Benjamin Franklin

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