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What is a 529 (qualified state tuition) plan and how does it work?

At a glance:

  • Types of state tuition plans

  • Taxes on 529 plans

  • 529 plans and other education plans

  • Summary of 529 plans

U.S. states have pre-paid tuition programs allowing families to save for their kids’ higher education.

These plans qualify for special tax treatment if the funds are used for qualified expenses at a post-secondary school that meets U.S. Department of Education standards for student aid eligibility.

These plans are generally referred to as 529 plans for the tax code section that describes how they are treated for tax purposes. States offering such plans may also give favorable tax treatment for contributions, interest, dividends, and distributions from these plans.

Types of state tuition plans

State tuition plans fall into two categories: pre-paid tuition plans and college savings plans.

How to buy pre-paid tuition plans

Pre-paid tuition plans allow participants to buy tomorrow's education at today's prices.

They may be purchased with a single lump sum or a series of payments. The state typically guarantees that the pre-payments will cover the future cost of education at the state college.

If the student chooses not to attend the state college, the state will often make available the amount of money equivalent to the cost of the state education at maturity.

For example, imagine that a state university costs $8,000 per year today and you pre-pay two years ($16,000), to be redeemed in 8 years. In 8 years, the cost of two years at the state college goes to $24,000. The beneficiary has two years paid for.

Should the student wish to attend a non-state school costing $30,000 for two years, the state has to rebate only $24,000 (the cost of the equivalent state college tuition).

Savings plans

State college savings plans have become more popular because of investment flexibility and the alluring possibility that, with investment skill and luck, proceeds may exceed the actual costs of education.

These plans have some tax incentives, too. While the contributions generally are not tax-deductible, the accumulation within the plans is tax-deferred until withdrawn.

Here's what you should know about education programs like 529 plans. (Graphic: Hannah Smart/Cashay)
Here's what you should know about education programs like 529 plans. (Graphic: Hannah Smart/Cashay)

Even then, the accumulations may be tax-free if used for qualified educational expenses. Contributions to a plan may not exceed more than the amount necessary to provide for the qualified higher education expenses of the beneficiary (student).

The contribution limits are often set by the plan administrator each year.

What higher educational expenses include

Qualified higher educational expenses include tuition, fees, books, reasonable room and board, supplies, and equipment required for the beneficiary at an eligible educational institution. The student must be enrolled at least half time.

Taxes on 529 plans

There are no income taxes due on the value of 529 plans until the proceeds are distributed. Then income tax is due only on the increased value of the plan over the contributed amount. The taxes are calculated at the beneficiary's rate, i.e., based on the student's income. Some states even waive income tax on funds used for qualified educational expenses.

If funds are disbursed and not used for qualified education expenses, a 10 percent IRS penalty may be due unless the disbursement meets special requirements. The penalty may be waived if the refund of earnings is made because:

529 plans and other education plans

Amounts can be transferred to other qualified state tuition programs, and beneficiaries can be changed.

Amounts in a qualified state tuition program can be transferred tax-free to the qualified state tuition program of another beneficiary.

The transfer must be completed within 60 days of the distribution, and the other beneficiary must be a family member of the beneficiary from whose program the transfer is made. The new beneficiary must be the existing beneficiary's spouse or one of the family members listed below:

  • Child or descendant of child.

  • Stepson or stepdaughter.

  • Brother, sister, stepbrother, or stepsister.

  • Parent or ancestor of parent.

  • Stepfather or stepmother.

  • Brother or sister of father or mother.

  • Son or daughter of a brother or sister.

  • The spouse of any individual listed above.

529s vs Coverdells

Qualified state tuition plans are more popular than the Coverdell education savings account because of the higher contribution limits and the ability to use qualified expenses as the basis for the Hope tax credit or lifetime learning credit. Unlike several years ago, contributions can be made to both a 529 plan and a Coverdell account.

The contributions limits to Coverdell accounts must still be respected, however. (The limits apply to the total of all contributions for a given beneficiary, as well as restricting the amount that higher-income donors may contribute.)

Summary of 529 plans

Is a prepaid tuition plan for you? There are advantages and disadvantages.

When compared with a Coverdell account, you can sock away more with one of the two types covered here. The savings plan version allows greater investment flexibility and the potential for earnings on your investment.

On the other hand, if you do not use your funds for qualified expenses, you could suffer an IRS tax penalty.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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