Heading Back to School: Overview of 529 Accounts 101

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As we creep closer to the beginning of the new school year, we’re often approached by parents and grandparents seeking information on how to begin saving for their child or grandchild’s college expense. We are not surprised by the number of questions because let’s face it, college is expensive. In many cases, to combat this ever-growing expense, we suggest setting up a 529 plan account because of the tax advantages associated with it when used for college. Here are some of the most frequently asked questions we get in regard to the 529.

Are 529 plans a good way to save for college?

Yes, they can be an excellent way to save for college. 529 savings plans are popular because they combine many desirable tax features with the ability to use the money at any accredited college in the country or abroad. Your contributions grow tax deferred and withdrawals are tax-free at the federal level if used to pay the beneficiary’s qualified education expenses. Many states also add their own tax benefits, such as a tax deduction for contributions and exemption of the earnings from state income tax.

What happens to the funds in my 529 plan if my child gets a scholarship?

If your child receives a full or partial scholarship to college, you can withdraw funds in your 529 account up to the amount of the scholarship each year and use the funds for a non-educational purpose without incurring the 10% federal penalty that would normally apply to the earnings portion of the withdrawal. In order to avoid the penalty, the withdrawal must be made in the same year that the scholarship is received and must not exceed the amount of the scholarship. However, you will still owe federal (and possibly state) income tax on the withdrawal. Each withdrawal is pro-rated between contributions and earnings; only the earnings portion is taxed (at ordinary income tax rates).

What happens to the funds in my 529 plan if my child doesn’t go to college?

If your child decides not to go to college, you basically have two options: change the beneficiary or withdraw the money.

All 529 plans allow the account owner to change the beneficiary. As long as the new beneficiary is a qualifying family member, no taxes or penalty will be due.

If you decide to withdraw the funds for non-educational purposes, you’ll owe federal income tax and a 10% penalty on the earnings portion of the withdrawal and probably state income tax too. (An exception to the 10% penalty exists if the beneficiary were to die or become disabled and not go to college).

How will my 529 plan be treated for financial aid purposes?

Parents as account owner: Under federal financial aid rules, the value of a 529 plan is listed as a parent asset on the government’s aid form, the FAFSA, if the parent is the account owner. A 529 plan that is owned by a student or funded with UTMA/UGMA assets is also reported as a parent asset on the FAFSA if the student is a dependent student. Under the federal aid formula, a parent’s assets are assessed (counted) at a rate of 5.6% (this means that 5.6% of a parent’s assets are deemed available to put toward college expenses each year).

Grandparents as account owners: The rules are different for grandparent-owned 529 accounts. If a grandparent (or other relative) is the account owner of a 529 plan, then it is not listed as a parent asset or student asset on the FAFSA. So, it doesn’t count as an asset at all. However, withdrawals from a grandparent-owned 529 account are counted as student income on the FAFSA the following year. Under federal aid rules, student income is counted at 50%, which means that a student’s financial aid eligibility could drop by 50% in the year following a 529 plan withdrawal.

Can you deduct contributions made to the 529 account?

You cannot claim a federal income tax deduction for contributions made to your 529 plan. However, certain states (Missouri and Illinois included) offer state income tax deductions for contributions to their state sponsored 529 plan.

Can the funds in my 529 plan be used for room and board, as well?

Yes, under certain restrictions. For students enrolled on an at least half-time basis, room and board costs for students living on-campus are limited to the actual amount charged by the school or to the amount most residents are charged, whichever is higher. Room and board costs for students living off-campus, including students living with their parents, are limited to the amount the school decides reasonable. Each state’s plan will spell out the guidelines that govern room and board expenses and what procedures to follow when requesting a withdrawal.

What is the best age to start a 529?

Typically, the sooner, the better. We like to say that a 529 should be started when a child receives a social security number. The earlier the 529 is started, the more time there is for potential growth to compound. However, with that said, they can be started at any time. Just keep in mind that systematic savings at an early age may allow for small contributions to “add up” to large sums when it is time for college.