How Are 529 Plans Taxed?

Parents who hope to see their children graduate from college need to start saving for that expense as soon as they can.

Fortunately the 529 Savings Plan allows parents to use tax-free investment earnings to pay for education. The 529 plan works this way: Parents, grandparents or other supporters put after-tax money in the 529, and that money is invested so that the account grows. When withdrawn, the money is not taxed as long as it is used for qualified education expenses.

This is a major boon for parents because the cost of higher education is staggering.

The average cost of college is $36,436 per year – or $145,744 for the entire four years. That price is higher at private schools, where the average cost is $55,840 – or $223,360 for four years.

Many students borrow money so they can meet those expenses, but that isn’t ideal because it leaves them with eye-watering debt, if/when they graduate. In the middle of 2023, the average amount owed by each student loan borrower was $37,650 – and totaled $1.77 trillion.

All those numbers should make parents queasy and spur them to act.

With a commitment to saving, an effectively managed 529 can be a big help in paying for the cost of higher education, especially because of the tax advantages.

Put simply, the 529 plan reduces the burden of paying for college.

What Is a 529 Plan?

A 529 is a savings/investment account designed to encourage saving for the cost of education. Most students use the 529 plan for college, but it can also be used for apprenticeships, trade school, graduate school and private elementary or high school.

The plan has significant tax advantages; earnings in the account are not taxed when used for qualified educational purposes.

Money from a 529 plan can pay tuition, room and board and associated college or trade school expenses (books, laptop if necessary). Up to $10,000 annually can be used for private elementary or secondary education. A 529 also can be used for graduate school, law school, and even to repay student loans, which may have been needed if there was not enough in the 529 plan to cover all costs.

The plans are run by states, which arrange for an investment company to set up and manage the accounts. Each plan can have a number of designated investment options.

As the investments grow and savings increase, the 529 account grows. The ultimate goal would be to have enough in the account when your child turns 18 to pay for a significant portion of the cost of college, perhaps even all of it.

If that helps your son or daughter graduate without a loan, all the better.

Let’s take a look at the two 529 plans.

Education Savings Plans

An Education Savings Plan helps students and parents pay for the costs of education – including books, room and board and tuition – and can be used to pay for any college. Because the student uses the money at the college of his or her choosing, this plan is by far the most common type of 529 plan.

In this kind of plan, the account holder contributes money toward a chosen state plan, and the money is invested in options determined by that state. These accounts grow tax deferred, and withdrawals are not taxed as long as they are used for qualified education expenses.

Money from an education savings plan can be used at any college or university. Education Savings Plans are available in all 50 states.

Prepaid Tuition Plans

Prepaid tuition plans allow a parent to pay for future college tuition at today’s costs. That can be a significant savings if the child is 10-to-15 years away from attending college.

Tuition can be paid in a lump sum, or in regular installments. The money is withdrawn tax free when the child goes to college and is guaranteed to cover the cost of tuition at the time the student enrolls. Neither earnings nor withdrawals are taxed.

Prepaid tuition plans only cover tuition and mandatory fees, not room, board, and supplies. Most plans are available only to in-state residents. The money can be used for out-of-state colleges, but without the benefit of the guaranteed tuition.

It should be noted that prepaid tuition plans are only available in nine states: Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, and Washington

How Are 529 Plans Taxed?

Money withdrawn from a 529 is not taxed as long as it is used for qualified educational purposes.

This is one of the best features of a 529 plan. Money invested is after-tax money, and earnings and withdrawals are not taxed when used properly.

Imagine saving regularly for your child’s schooling, and that you have $100,000 in the 529 account when he or she is ready to enroll. If the money is spent equally over four years, $25,000 could be withdrawn each year and used to pay for tuition, room and board and necessary supplies. That $25,000 is not taxed.

There is a price to pay for not using the money properly, though. Funds withdrawn and not used for education will be taxed. In addition, a 10% penalty must be paid. This explains clearly why it’s important to use the money for qualified expenses only.

But the benefit of using tax-free earnings is significant – and a reason the 529 is so popular: Americans in total have $432 billion in these accounts.

Qualified Expenses

Qualified expenses that 529 money can be used for:

• Tuition
• Room and board, including a dorm or apartment (up to the cost of the dorm)
• Books
• Computer technology or equipment, like a laptop and needed software
• Mandatory fees
• Necessary supplies

Congress now also allows 529 money to be used for private elementary school and high school, though there is an annual limit of $10,000. A 529 plan also can be used for vocational or technical schools. Of course, any money spent for K-12 education will be money not available when the college bill arrives.

Are 529 Contributions Tax Deductible?

Money contributed to a 529 plan is not tax deductible on the federal level, but more than 30 states allow credits or deductions of differing amounts on 529 contributions.

Ohio, for instance, offers a deduction of $4,000 per beneficiary; Oklahoma $10,000 for single filers and $20,000 for joint filers; Oregon offers a $150 tax credit for single filers, $300 for joint filers.

Nine states have no income tax and no 529 deductions: Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Four states simply do not give a tax benefit for 529s: California, Hawaii, Kentucky, and North Carolina.

Tax Advantages and Disadvantages of 529 Plans

Any plan that offers tax-free earnings and withdrawals is hugely beneficial, however there are some aspects of 529 plans that could be cause for reconsidering.

Advantages

The biggest advantages of a 529 plan include:

• A high contribution limit. Though some states limit the total contribution amount (from $235,000 to $525,000), there is no limit to what can be contributed in a single year.
• Flexible plans. Investors can choose the state plan they prefer, even if it’s not their state.
• Easy to open and maintain. A financial advisor familiar with college savings makes this a smooth process.
• Tax-exempt growth. Money is not taxed if used for qualified educational expenses.
• Money can be used for many purposes. Investors in an Education Savings Plan can use 529 money to pay for elementary school, high school, and college as well as trade and technical schools. And the money can be used for any school in any state, though the Education Savings Plan offers more flexibility.
• Starting in 2024, leftover money (up to $35,000) can be transferred to a Roth IRA in the beneficiary’s name.

Disadvantages

Some of the disadvantages of 529s include:

• Limited investment options. Each state chooses where money can be invested. While each state typically has several options for investing, savers are limited to those choices.
• Different fee costs per state. A financial advisor should make these costs clear.
• Must be used for qualified educational purposes. A Prepaid Tuition plan pays tuition. Educational Savings plans have specific uses, all involved with education.
• Money not used for qualified educational purposes will be taxed, and a 10% penalty assessed. That penalty could be a few thousand dollars; the mere idea of paying it hurts.
• Knowing how much to spend can be a guessing game. It’s not difficult to wind up with too much or too little in the account when college time arrives. However, federal rules on how that leftover money can be used have eased.

Can 529 Plans Be Transferred?

Money in a 529 plan can be transferred after college or graduate school, but certain rules apply.

Unused or leftover money could be transferred to another family member – the beneficiary’s sibling, for example. This could be a big help to a younger sibling who also wants to attend college.

The ability to transfer leftover money up to $35,000 to a Roth IRA becomes an option in 2024. This kind of transfer could help a young person start to save for retirement.

If your child earns a scholarship that pays for his or her college, or attends one of the military academies, you may withdraw the amount equal to the scholarship from the 529 account without having to pay the 10% penalty tax. However, you will have to pay income taxes on the earnings portion of the withdrawal. State and local taxes may also apply.

Is a 529 Plan Right for You?

A 529 is a very viable plan when saving for college. Many young Americans have benefitted from the generous savings of parents or grandparents. The fact that withdrawals are tax free is a huge benefit.

However, as with any kind of savings plan, discipline and commitment are required to start and maintain a growing and healthy account.

Those who are unsure where to start could explore the best ways to save for college. Those who are dealing with budget or debt issues also could receive credit counseling, where a nonprofit credit counselor assesses your financial situation and offers the best solution for you.

Saving for college may not be easy, but the work of committing yourself to saving pays off when a college student’s tuition is paid for by money you’ve been setting aside for years.

The thought of using tax free earnings from an investment to pay for tuition from an account like a 529 brings a great deal of satisfaction – especially if it means your child avoids student loans.