Saving for college is one of the most common goals parents have for their children. College is expensive—and getting more so each day—and families with decent incomes have less favorable financial aid options, but they are in the fortunate position of being able to save to help cover those costs.
Since 1996, the primary college savings vehicle has been the 529 plan, which comes from Section 529 of the Internal Revenue Code. These plans offer a lot of flexibility and tax benefits, which make them very attractive, but there are so many options for 529 plans now that they can feel confusing.
So, let’s try to clear up a couple of key misunderstandings. First, 529 plans are sponsored by individual states and several states offer more than one variety. However, you are NOT required to use the plan from the state you live in. Some states offer tax incentives to their own residents, but the market is competitive and you may find another state’s plan you like more for one reason or another.
Also, no matter which state’s 529 plan you use, in most cases, the proceeds can be used at any college, university, or vocational school eligible to participate in a student aid program administered by the Department of Education. So for example, if you live in Texas, it’s perfectly fine to use Virginia’s 529 program to save for your child even if they end up attending college in Florida. Make sense?
The main advantage is that contributions can be invested in a variety of options within the plan based on your goals, time frame, and comfort with market volatility. Any growth is not subject to federal tax and generally not subject to state tax when used for qualified education expenses, such as tuition, fees, books, and room and board.
Unlike most other types of accounts, which provide tax-free withdrawals, there is no income restriction on who can set up or contribute to 529s, so they’re a great option for high-income families like physicians and dentists.
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One of the other main questions people have is- What should I do with the 529 Plan if my child ends up getting a scholarship?
Well, if your child ends up getting a scholarship, you might not need all the money you've saved up in your 529 plan for college expenses. You generally have four options at that point.
(Option 1) Leave the money there for some future use by that child, perhaps for graduate school.
(Option 2) Direct it to another family member, such as a sibling or a future grandchild.
(Option 3) Withdraw the extra funds. The earnings in your account will be subject to income tax, either on your return or your child’s. Normally, there would also be a 10% additional federal tax on the earnings portion, which is a penalty for taking a non-qualified withdrawal, but the penalty is waived when scholarships are the reason for it.
(Option 4) With the new regulations, effective January 1, 2024, 529 plan account owners or beneficiaries can roll over 529 funds into a beneficiary-owned Roth IRA tax-free and penalty-free. This is subject to limitations. If you qualify, this can be a great way to help kick-start a beneficiary's retirement savings.
In effect, the scholarships have turned your tax-free 529 investment into a tax-deferred 529 investment. Of course, most scholarships don’t cover ALL the expenses of college, so you’ll still be able to use the 529 for other expenses such as room and board, books, and supplies.
Obviously, there are many details surrounding 529 accounts. If you have more questions, feel free to contact one of our financial planners, or you can check out the IRS website and search for Publication 970, Tax Benefits for Education.
There is no guaranteed rate of return. The risk with a 529 Plan is that the investments may not perform well enough to cover the rising cost of college as anticipated. Past performance does not guarantee future results.
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Shane Tenny is the managing partner of Spaugh Dameron Tenny. Along with hosting the Prosperous Doc® podcast, Shane has a true passion for behavioral finance, helping clients and audiences understand how to develop successful strategies based on their unique temperaments. An accomplished and highly engaging speaker, Shane is regularly interviewed for television and podcasts, is actively involved in the Financial Planning Association®, and contributes to industry advisory boards.
