529 Plans & Taxes

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Published by Mark Lookabill | @LookabillMark

It is hard to believe that the 529 Plan is now 20 years old. I often receive the question, “Is a 529 Plan tax deductible?” Over the last two decades, the 529 Plan tax benefit has helped a number of taxpayers absorb some of the costs for college. Let’s explore the tax benefits below.

Savings Plans vs. Prepaid

The 529 Plan really comes in two forms: 1.) Prepaid college tuition plans and 2.) College savings plans. The popularity of the prepaid tuition plans has gone down over the last few years. Some plans have even stopped accepting new enrollees or eliminated the prepaid tuition plan completely. The biggest reason for the reduced popularity is that the plan can only be applied to tuition and fees of in-state schools thereby limiting the choice of schools that a student may look at attending. Additionally, room and board, books and other expenses are typically not included and must be covered separately.

Understanding Your Investment Choices

There are a few different ways you can go about managing or selecting the investment allocation tools within a 529 Plan. It is crucial that an investor understand the positives and negatives of each of these choices.

First, an age-based allocation within a 529 plan automatically adjusts to reduce equity risk as the beneficiary or student approaches college age. This means that as the child becomes older, the exposure to equities is reduced and allocation to bonds and cash increase.

Another option is what I refer to as the “set it and forget it” option in which an investor selects a certain asset class and leaves it alone over the life of the 529 Plan. The benefit of this is it removes all decision-making. However, investors must also know that this can lead to periods of volatility and account decline. This option is best for someone who does not have the time or expertise to look at and monitor the 529 Plan or someone who is comfortable recognizing that there will be periods of market volatility and they are comfortable with that because they are focused on the long-term.

Who Will Use the Funds

One of the biggest benefits beyond 529 Plan tax benefits is some of the flexibility in terms of who can use the funds for higher education expenses. The typical scenario is that a parent or grandparent creates a 529 Plan for the child or grandchild with those funds being able to grow tax free as long as they are used for higher education. One of the positives of a 529 Plan is the ability to change beneficiaries as circumstances warrant. Let’s say you create a 529 Plan for your child when they are still an infant and then as they approach college-age, they are either eligible for merit based financial aid in which case 529 Plan funds are not needed or perhaps they decide not attend college. In these instances, you can name a new beneficiary so long as it is a family member of the former beneficiary. This can include siblings, cousins, etc. You can even name yourself as the new beneficiary if you desire to go back to school.

529 Plan Tax Rules

When it comes to the rules and nuances of 529 Plans, most people will benefit from seeking the advice of their financial advisor or tax preparer. Generally speaking, the funds from a 529 Plan can be used for most accredited colleges and graduate schools including professional and trade schools. The funds can be used for a variety of qualified education expenses including tuition, books, and room and board. To get a full understanding of 529 Plan tax benefits, you should consult your tax preparer particularly as it relates to which plan to select. This is where I counsel people not to limit themselves to only their state’s offering. You need to look at your own individual circumstance to determine what is best for you.

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