I'm part of a Facebook group of Asian moms. We talk about kids, marriage, fashion, and, you guessed it, money. Ninety percent of the time, the money question would be a variation of "How do I save for my kids' future"? It's not surprising that our community focuses so much on saving for kids. According to a 2019 Prudential report, Asian Americans place significant importance on financial goals that support their children and parents. With 529 plans designed to help families save for education expenses, it's the perfect time to explore what they are and are not.
What are 529 plans?
529 plans are state-sponsored, tax-advantaged investment vehicles to help families save for future education expenses. These plans come in two flavors: prepaid tuition plans and education savings plans. Prepaid tuition plans let families lock in current tuition rates for future, whereas education savings plans provide more flexibility and can be used for a wider range of qualified education expenses. Education savings plans are more widely adopted, so we'll focus on them here for simplicity's sake.
Main characteristics of 529 plans
Tax Advantages One of the most significant advantages of a 529 plan is its tax benefits. On the federal level, earnings in 529 plans grow tax-free, and qualified withdrawals for education expenses are exempt from federal taxes. It means that the growth of your investment will not be subject to tax as long as the funds are used for qualified education expenses. The state-level tax treatments vary: Over 30 states offer tax deductions or credits for contributions to their own 529 plans; some states offer tax benefits for any 529 plan, while others don't offer state-level tax incentives. You can check here for your state's tax treatment of 529 plans.
Broad Qualification 529 plan funds can cover educational expenses beyond just tuition. What goes in the list of qualified education expenses might be longer than you think: In addition to college tuition, you can use 529 to pay for books, room and board, etc. With recent years' changes, most states even allow 529 plans for K-12 private school tuition, in addition to undergraduate, graduate, vocational, and trade schools expenses.
Control and Transferability There are two parties to a 529 plan - the owner and the beneficiary. For example, my husband have a 529 plan with our daughter as the beneficiary (Plan A) and I have a 529 plan with our son as the beneficiary (Plan B). My husband is the owner of Plan A, and our daughter is the beneficiary. I am the owner of Plan B, and our son is the beneficiary. The account owner maintains control of the 529 plan and can change the beneficiary as many times as necessary, allowing for the transfer of unused funds to another qualified family member without tax penalties. See list of qualified family members here. Additionally, starting in 2024, SECURE ACT 2.0 has also provided additional flexibility for 529 plan to convert up to $35,000 into a beneficiary's Roth IRA, making it even more flexible. See limits and requirements here.
Limited Investment Options 529 plans are similar to 401(k) plans in this regard. 529 plans offer you a limited menu to invest in, unlike an IRA, where you have a much broader set of investments. Since each state operates their own plans, you could have investments that cost anywhere from 0.05% to 1.97% (!!!) a year as of 2023. See complete list and pricing here. The good news is that you can explore outside your state's plan if you don't like how much it costs. We'll talk more about this below.
What 529 Plans Are Not
I often hear descriptions that are not so accurate about 529s. It's understandable since there have been quite a few changes lately on what it applies to, and some states have a slightly different set of rules. Here are some of the most common myths about 529 plans:
Only for College Tuition As discussed earlier, 529 plans can cover anything deemed "qualified education expenses". You can see the full list of qualified education expenses here.
You can only invest in your own state's plan While some states may offer additional tax benefits to residents who invest in their state's plan, most 529 plans are open to residents of any state, and you are not restricted to investing only in your state's plan. As we discussed earlier, if your state doesn't offer tax incentives and has high-cost investments, there's no reason you should only choose a plan within your state.
Significantly Impacting Financial Aid Eligibility While 529 plan assets are considered in financial aid calculations, their impact is relatively minimal, as they count as the parent's assets. This classification results in a more favorable treatment compared to assets held in the student's name. Additionally, the impact on financial aid eligibility varies depending on the plan's ownership. For example, grandparents' assets are not considered in financial aid calculation, so a grandparent-owned 529 would not impact financial aid eligibility.
Use it or lose it Some people fear losing all the money in a 529 plan if the beneficiary does not attend college. However, this is not the case. Several options are available, such as changing the beneficiary to another family member, rolling up to $35,000 into beneficiary’s Roth IRA, etc. Worst comes to worst, you would always have the option to make non-qualified withdrawals after paying penalty and taxes.
A lot of the 529 plan inspiration came from Ann Garcia and her wonderful book, How to Pay for College. If you’re a parent that is really focused on this chapter of your kids’ life, I highly recommend reading this book.
Cheers,
Lei Deng, CFA, CFP®
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