As a parent, grandparent, aunt, uncle, or friend, you’re eager to see the young people in your life succeed, and you do what you can to foster that success.
One way to give back is through a 529 plan, which helps fund a beneficiary’s educational endeavors.
If you’re interested in opening a 529 for your loved one, consider the following 5 first steps, 2 tips, and 9 FAQs.
Want to learn how to use a 529 plan? Start with these 5 steps:
1. Ensure you have a strong financial foundation.
Your financial health is your oxygen mask. Secure it before you decide to support someone else.
- Are you saving enough annually for retirement (10-15% of your overall income)?
- Have you paid down debt?
- Is your current cash flow healthy?
- Are there any large purchases you’d like to make?
Remember, you can borrow for college, but you can’t borrow for retirement.
2. Consider your loved one’s educational future.
529 plans are a great vehicle for funding qualified educational expenses, but they are not the best option for everyone. Although the definition of a qualified educational expense is lenient, your loved one may not be interested in higher education or may have other means of paying for it.
For general giving, consider a gift trust or custodial Roth IRA. While these do not boast all of the same benefits as a 529 (e.g., gift trusts do not grow tax-free), they may be helpful for anyone unsure about a child’s educational aspirations.
3. Review your state’s 529 plan.
Each state has its own 529 program, and while you are not required to use your state’s plan, some states offer a state income tax credit if you choose to do so, such as a dollar-for-dollar credit (i.e., put in $1, get $1 back on state income taxes) or a matching percentage credit (e.g., put in $100, get $20/20% credit back on state income taxes).
Weigh your options and consider whether your state’s offering is worth it. Some state’s 529s are expensive and may not be the right choice, even with a tax credit. Ensure you also understand the plan’s state income tax credit recapture rules (reasons you might have to return a tax credit), if applicable.
4. Determine overall costs.
A 529 plan may be advisor-sold, where the advisor earns a commission for investing your contributions in the 529 plan. The other option is a direct 529 plan. A direct plan is often cheaper because you aren’t paying an advisor a commission. At Credent, we are commission-free and encourage many of our clients to save money and purchase their plans directly.
Make sure you understand all of the costs associated with whatever plan you select.
5. Choose your contribution.
How much you can contribute to a 529 plan depends on your family’s cash flow. Remember – generally, it doesn’t make sense to skimp on retirement contributions to fund your loved one’s education, especially in light of student loans and scholarships.
Otherwise, with the rising cost of post-high school education, you usually can’t contribute “too much.” However, it’s always best to consult your financial advisor to help you decide what amount works for you.
Once you open your 529 plan, here are 2 additional tips:
- You don’t have to contribute alone – If family and friends want to support your loved one, suggest they contribute to your 529 plan, assuming they don’t open their own.
2. Leftover funds are not a problem – If the original beneficiary doesn’t want or need all the funds, transfer the beneficiary to another child or grandchild, or, if you go back to school, make yourself the beneficiary. One note here – skipping two or more generations could have tax implications. If you no longer want to oversee the 529 plan, you can also transfer ownership.
Still have questions about how to use a 529 plan? Here are 9 FAQs:
1. Is a 529 plan a reliable college savings option?
With a 529 plan, you invest money and let it grow over time. Whatever it grows to is what you have. As with any investment, there is risk, but, like other investments, if you play the long game, you will most likely come out ahead.
Even with a 529 plan, it’s wise to find additional ways to save and pay for college.
2. Does it make sense to open a 529 plan with yourself as the owner and beneficiary?
Some high earners know they want a family someday. These individuals can open an account and designate themselves as the beneficiary until they have children or someone else to sub in.
Other individuals want to minimize future estate taxes. If they open a 529 plan as the owner and beneficiary, this money is still within their estate. However, if they let this money grow and eventually select a new beneficiary, the 529 will no longer be a part of their taxable assets and can be used as a scholarship for a candidate of their choosing. (They do need to be aware of any annual or lifetime gifting limitations.)
3. The money in a 529 plan can be used for educational expenses other than higher education. Would you recommend other uses?
529 plans are liberal on what qualifies as an educational expense. For instance, recent changes allow 529 plans to be used for K-12 tuition for private, public, or religious schools (up to $10,000 per year per beneficiary). However, higher education is one of the best uses because it tends to be the furthest educational milestone, giving the money longer to grow tax-free.
Even if the beneficiary transfers to the next generation, the longer the new beneficiary waits to use the funds, the more they benefit from the growth potential.
4. What is the difference between a 529 savings plan and a 529 prepaid tuition plan?
There are two types of 529 plans—prepaid tuition plans and savings plans. When you put money into a 529 savings plan, whatever it grows to is how much you have to distribute for educational expenses.
With a 529 prepaid tuition plan, you lock in current prices. For example, if a college class costs $5,000 today and you invest $5,000, you’ve prepaid for one class, regardless of the inflation on tuition over the next 20 years. However, most prepaid tuition plans don’t cover other expenses, such as room and board.
While prepaid tuition plans fell out of favor, as schools overestimated what they could make on the prepaid money, versions of prepaid plans, such as the Private College 529 Plan, are coming back.
Ultimately, consult your financial advisor when deciding what makes the most sense for you.
5. Why might someone opt to open a 529 plan instead of a custodial Roth IRA?
Both a 529 plan and a custodial Roth IRA can be a great way to give back and utilize tax-free growth. However, there are some key differences:
- Unlike with a 529 plan, to open and contribute to a Roth IRA for a minor, that minor must have earned income, even a small amount.
- Both plans have their own distribution limitations. 529 plans are limited to qualified educational expenses and are available within the year that the expense occurs, like a reimbursement, or they can be sent directly to a school. The owner of a Roth IRA can only take tax and penalty-free distributions of earnings when they reach 59 ½ (with some exceptions).
- With a 529 plan, you maintain ownership and designate a beneficiary. When you open a Roth IRA for a minor, they are the owner, and you are the custodian until they turn the age of majority. In most states, this is 18, but it can be as high as 21 in others.
- Some 529 plans have a maximum balance, and givers should be aware of the annual gift exclusion threshold. Contributions to a Roth IRA are restricted by an annual contribution limit. (In 2024, this is $7000.)
Of course, you can open both a 529 and a Roth IRA on behalf of a loved one.
6. If I’m contributing to a 529 plan, what strategies or rules should I consider?
First, if you are not the owner of the 529 plan, be sure you trust the owner. If you’re unsure, you can always open your own 529 plan for the benefit of the same person. Owners and beneficiaries can have multiple 529s.
If you are contributing to someone’s 529 plan as a grandparent or other family member, consider the $18,000 annual gift exclusion limit. If you give more than this limit, you may need to file a gift tax return, but this does not necessarily mean you’ll owe taxes on the gift. The excess amount will count towards your lifetime gift tax exemption, which is not an issue for most households.
Another strategy to consider is superfunding the 529 plan, which is discussed in more detail next.
7. What does it mean to superfund a 529?
Superfunding a 529 plan means giving five years’ worth of gifts to a single beneficiary in one year. So, for example, if Grandma and Grandpa are planning to give $18,000/year for the next five years to a 529 plan, they can each contribute a 5-year forward gift of up to $90,000 ($18,000 x 5) for a total of $180,000.
This removes $180,000 from their estate, minimizing estate taxes and allowing the gifts to start growing tax-free sooner in the 529.
One caveat is that if Grandma or Grandpa were to pass within five years of the initial gift, their gift can be recaptured. Any additional gifts during these five years could require filing a gift tax return, as discussed in #6 above.
8. What are some distribution strategies for a 529 Plan?
One thing to consider is how the money in a 529 plan affects the beneficiary’s financial aid.
For instance, if a child has both a parent-owned and a grandparent-owned 529 plan, it is advisable for them to distribute funds first from the parent-owned plan. Whether distributed or not, a parent-owned plan counts towards the child’s Expected Family Contribution (EFC) and could adversely affect their financial aid.
On the other hand, grandparent-owned 529 plans may or may not affect financial aid. Under new rules, the FAFSA does not count a student’s cash support, regardless of the source (including distributions from grandparent-owned 529 plans). However, these assets and distributions may still be considered on the CSS Profile (College Scholarship Service Profile).
If you have more questions about distribution strategies, talk to a financial advisor.
9. I’ve heard we can now roll over a 529 into a Roth IRA – is this a big advantage?
As of 2024, a 529 plan can now be rolled over into a Roth IRA. However, there are restrictions that hinder the benefits of this opportunity.
The reality is that most 529 plans are fully distributed. If there is leftover money to roll over, you must meet the proper criteria, including:
- The 529 plan must be established for at least 15 years. As of now, a change in the beneficiary may restart the 15-year clock.
- Whatever assets will be transferred from the 529 to the Roth IRA must have been in the 529 for at least five years.
- Assets from the 529 account must roll over into a Roth IRA owned by and in the name of the beneficiary of the 529 account.
- The owner of the Roth IRA/beneficiary of the 529 Plan has to have earned income, with the rollover amount being the lesser of their earned income or the annual IRA contribution limit.
- You must abide by annual Roth IRA contribution limits. This is the total cumulative amount contributed in a tax year (not just a calendar year), including both 529 rollovers and regular Roth IRA contributions. You cannot roll over more than $35,000 total from a 529 to a Roth IRA.
A rollover may also trigger a recapture of state income tax credits given for 529 contributions.
If you plan to contribute to your Roth IRA anyway and have unused money sitting in a 529 plan, it may make sense to roll it over, assuming you meet the criteria. Ultimately, though, this new allowance may not be the advantage some people believe it to be.
For more answers on how to best use a 529 plan, reach out to an advisor using the form below.