Millions of families use a 529 college savings plan as part of their savings strategy, as roughly $400 billion is held within these plans nationwide. Still, some investors may not realize the full range of benefits that these plans may provide. Indeed, a 529 plan is more than a savings vehicle and can also be a useful tax strategy.
The structure of a 529 plan is conducive to building savings. But there are many considerations for account owners looking to optimize their college savings as part of an overall tax plan.
Here are ways that families can maximize a 529 plan.
- Start saving early and set at least some contribution level to auto-pilot. The earlier that savings begin, the longer the timeframe to navigate different market cycles. The assets can potentially take more investment risk with a longer time horizon
- Remember that 529 plans offer the flexibility to use the funds for certain K–12 expenses (up to $10,000 per beneficiary per year) or use distributions to pay off student loans (lifetime limit of $10,000 in aggregate per beneficiary)
- Encourage grandparents and other relatives to get involved. A 529 plan has a front-load option allowing for five years of annual gifts in one year (up to $75,000 based on current gift limits). For grandparents, there is a “gifting with strings” opportunity, meaning that a grandparent who is the account owner can always tap into the account (taxes and penalty applied to earnings) in case of an emergency. In this case, a non-qualified distribution to the grandparent would result in those funds being considered part of the grandparent’s estate. Given uncertainty around future gift and estate taxes, funding a 529 can help account owners remove assets from their taxable estate.
- Take advantage of state tax benefits if they apply. For more details see rules by state.
- Changing the account beneficiary if needed (for example, when one child decides not to pursue college, or one student gets a scholarship)
- Being smart about financial aid. In general, the Free Application for Federal Student Aid (FAFSA®) treats 529 assets owned by the parent more favorably than custodial minor accounts, which are considered assets of the student for federal financial aid purposes. There is also an income test as part of the financial aid qualification process. For example, the FAFSA calculation for federal financial aid counts 50% of a student’s income toward the Expected Family Contribution (EFC). This can lead to a drastic reduction in financial aid depending on how much income is recorded. The higher the income, the more funds the student will be expected to contribute to college costs. Income is defined broadly and includes sources beyond a workplace wage. Different types of income can affect a student’s financial aid award. Qualified distributions from a 529 or Coverdell account owned by a non-parent (for example, a grandparent) for the benefit of the child are considered as income to the student. This is an important consideration if distributing funds from a grandparent-owned 529. In this case, it may be better to wait until the last two college years to tap into a grandparent-owned 529.
- Make investment option exchanges within the plan twice per calendar year
Keep an eye on Capitol Hill
529 Awareness Month is not limited to May. In the past several years, lawmakers have introduced policies that positively impact the flexibility of 529 college savings plans. In addition to expanding the types of qualified expenses, some policies introduced during the pandemic were designed to help families stay on track with college savings. It’s important to continue to monitor potential tax law changes that could impact 529 plans. A retirement bill, Secure 2.0, which is advancing to the full House for consideration, includes a proposal allowing an employer matching contribution for employees who are making qualified student loan payments.
Additionally, a recent proposal introduced by the administration calls for higher taxes for certain higher-income taxpayers. In general, the tax advantages of 529 plans can be considered part of overall tax-smart planning. Families may be able to mitigate the impact of potential higher taxes in the future with tax-free earnings unique to 529 plans. Many states offer tax deductions for 529 plan contributions, and grandparent-account owners may be able to remove 529 contribution amounts from their total estate.
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.