Paying for College: A Guide to Section 529 Plans

Section 529 plans are tax-deferred savings plans that have been around since 1996. They are intended to help families save money to pay for college.

Whether you’re saving for a child’s education, your spouse’s, or even your own, contributions to a 529 plan grow tax-free, as long as the money is used for qualifying education expenses when withdrawn.

Similar to a Roth IRA, you won’t receive a federal tax deduction when you contribute money, but the money can grow tax free, as long as you “follow the rules”. More on the rules a little later.

But you may receive a tax deduction on your state income tax return.

Planning for college is best started early and if you’re new to 529 plans, we’ve got everything spelled out for you.

What is a Section 529 plan?

A Section 529 plan is used to contribute money toward future education costs.

They are administered by the individual states — hence why you might hear about a “California 529 plan” or a “New York 529 plan” — for colleges and universities.

But note that you do not have to live in a given state in order to contribute to that state’s 529 plan (more on this later).

Also known as qualified tuition plans, 529 plans take on two different forms:

•       savings plans and
•       prepaid tuition programs

Savings plans

Savings plans are more common than the prepaid tuition plans.

These plans are tax deferred plans that allow you to set aside money for a designated beneficiary’s education expenses.

You’ll invest the funds like you do with your 401k or IRA. The earnings on your contributions are tax-free so long as they are used to pay for qualified education expenses.

Prepaid tuition programs

Prepaid tuition programs allow you to buy units or credits at participating universities for future use by the account beneficiary. Participating universities generally are the public universities in the state sponsoring the plan.

You’ll lock in today’s tuition rates when you buy a prepaid tuition plan since you’re buying credit hours.

Which is best? Savings plans or prepaid tuition

The upside of savings plans is the flexibility. The money can be used at any university, college, or vocational school in the U.S., public or private.

It doesn’t matter what state the beneficiary resides in or what state the school is in. This flexibility doesn’t limit the beneficiary’s education options.

With savings plans, there is also potential to earn significant returns based upon your investment choices. If the economy is strong, you can reap the rewards of high rates of return.

But conversely, if the economy falls apart like it did in 2008 and 2020, there is also a downside risk of losing some of your investment.

Prepaid tuition plans help to eliminate the market risk associated with savings plans. You’re buying credit hours so you don’t have to worry if the market takes a nosedive.

However, the downside to prepaid tuition plans is the lack of flexibility.

Beneficiaries will be limited to attending one of the state’s public universities. If the beneficiary decides to attend a private school or a school in another state, the prepaid tuition plan isn’t as valuable.

Some plans will let you use the money at the receiving school. But this likely won’t be as valuable since you’ll be paying higher tuition rates at a private college or out-of-state resident rates.

And other plans may only provide you a refund of your contributions and a small rate of return on your investment.

What kinds of expenses can be paid with a 529 plan?

Qualified education expenses are higher education expenses, including tuition, room and board, mandatory fees, books, computers, and required software. These fees can be paid with funds in a savings plan.

Funds in a savings plan can generally be used at any college or university in the United States.

They can also be used for apprenticeship programs and K-12 tuition.

However, the K-12 tuition is limited to $10,000 per year, and some states don’t allow funds to be used for K-12 tuition. For example, Montana doesn’t recognize K-12 tuition as a qualified education expense and your withdrawal may be taxable on your Montana return if you file there.

Prepaid tuition plans typically only cover the future cost of tuition and mandatory fees.

For an additional fee, some plans allow you to add on packages for future room and board.

Maximum contributions

For savings plans, there is no annual contribution limit; however, federal gift tax limitations apply. For 2020, the gift tax exclusion limit is $15,000 per person.

Contributing more than this amount in a year can trigger the need to file a gift tax return.

However, many plans have a maximum that can be contributed in total per beneficiary. For example, Idaho’s savings plan sets a maximum of $500,000 per beneficiary and Iowa’s maximum is $420,000.

Starting and modifying a 529 plan

Who can start a 529 savings plan?

Usually parents or grandparents start 529 savings plans for children or grandchildren. But anyone can create a 529 plan.

You could create a 529 plan for yourself.

If you planned to attend college or graduate school in the future, you could start saving now. Simply name yourself as the beneficiary.

How to start a 529 plan

Start by looking at the different 529 plans available, and not just those in your state.

Many states don’t have a residency requirement to participate in their plans. So you could live in Texas but have a plan in Michigan.

You’ll want to consider the tax implications when selecting a plan. We’ll talk more on taxes later.

But some states provide a tax deduction when you make contributions to a 529 plan.

Don’t forget to look at the average investment returns on the plans and the investment fees you’ll pay.

Once you’ve found the plan that’s right for you and your beneficiary, contact the investment company that administers the plan. Many of the large investment firms administer 529 plans for the states.

For example, Fidelity administers plans for New Hampshire, Arizona, Delaware, and Massachusetts. Putnam, Vanguard, and online platforms like CollegeBacker can get your 529 plan started.

Had a change of plans? Can you change the beneficiary?

Perhaps your child receives a full-ride scholarship to college. Or they join the military after graduating high school.

What happens to the 529 plan set up in their name?

You’re allowed to change the beneficiary of a 529 plan without any federal tax consequences, so long as the new beneficiary is a member of the old beneficiary’s family. A family member is defined as:

•       son, daughter, stepchild, foster child, adopted child, or descendant of any of these
•       brother, sister, stepbrother, or stepsister
•       father or mother
•       ancestor of either father or mother
•       stepfather or stepmother
•       niece or nephew
•       in-laws, specifically: son, daughter, father, mother, brother, or sister
•       spouse of any of the above individuals
•       first cousin

Rollovers and transfers of 529 plans

Assets can be rolled over or transferred from one 529 plan to another or to an ABLE account.

ABLE (Achieving a Better Life Experience) accounts are tax deferred savings accounts for disabled beneficiaries. The funds are intended to help pay for qualified disability expenses.

The Tax Cuts and Jobs Act of 2017 allowed up to $15,000 per year to be rolled over from a 529 plan into an ABLE account. The ABLE account must be for the same beneficiary as the 529 account or someone from the beneficiary’s family.

The ABLE rollover provision is set to expire at the end of 2026 unless Congress votes to extend it.

Taxes: How are 529 plans taxed?

Federal taxes and contributions to 529 plans

There is no tax deduction on your Form 1040 for contributions to 529 plans.

Federal taxes and distributions from 529 plans

Generally, distributions from a 529 plan used to pay qualified education expenses are not taxable.

However, if distributions exceed the adjusted qualified education expenses, tax will be due.

Adjusted qualified education expenses are the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:

•       tax-free part of scholarships and fellowship grants
•       veterans’ educational assistance
•       tax-free part of Pell grants
•       employer-provided educational assistance
•       any other nontaxable payments (other than gifts or inheritances) received as educational assistance

Let’s look at an example.

Michelle’s parents started a 529 plan for her college education. At the time she started college, the plan had $30,000 in it.

The $30,000 is a combination of her parents’ contributions and earnings on the investment.

In her first semester, Michelle paid $9,100 in qualified education expenses. She paid these expenses with:

We need to reduce the qualified education expenses of $9,100 by the tax-free assistance she received. This is the $4,000 partial academic scholarship.

Michelle’s adjusted qualified education expenses are $5,100 ($9,100 – $4,000).

Since the adjusted expense amount ($5,100) is less than the 529 distribution amount ($6,000), some of this distribution will be taxable.

Michelle received a Form 1099-Q for her distribution and it showed that of the $6,000 distribution, $800 of that was for earnings on her parents’ contributions.

We need to calculate the taxable portion of the distribution. We’ll need to calculate the percentage of the distribution used to pay the adjusted qualified education expense.

So we’ll divide the adjusted qualified education expense by the total distribution amount.

Then we’ll take this percentage and multiply it by the earnings to find the amount of earnings that is tax-free.

$800 earnings times $5,100 adjusted qualified education expense divided by the $6,000 distribution equals $680 tax-free earnings

Michelle will need to include $120 ($800 – $680) in income on line 8 of her Form 1040 as taxable earnings from a distribution from a qualified tuition plan not used for qualified education expenses.

10% penalty on taxable distributions

Unless a distribution meets an exception, taxable distributions that are included in income are subject to an additional 10% tax.

The exceptions include:

•       Distributions paid to the beneficiary, or his estate, on or after the death of the designated beneficiary
•       Distributions made to a disabled beneficiary
•       Distributions included in income because the beneficiary received one of the tax-free education assistance items mentioned above
•       Distributions made because the beneficiary attended a U.S. military academy
•       Distributions included in income solely because the American Opportunity Credit or Lifetime Learning Credit was deducted from qualified education expenses

In our example above, Michelle wouldn’t be subject to the 10% penalty because she meets the third exception (distribution is taxable because she received tax-free education assistance).

Distributions and other education tax deductions and credits

You are allowed to claim the American Opportunity Credit, the Lifetime Learning Credit, or the Tuition and Fees Deduction (if you qualify) in the same year you take a distribution from a 529 plan.

You’ll have to reduce the qualified education expenses by the amount of the credit or deduction to arrive at the adjusted qualified education expenses.

Using the same example from above, assume Michelle’s parents claimed a Lifetime Learning Credit of $2,000.

Michelle’s qualified education expenses will be reduced by $2,000 from the lifetime learning credit. Her adjusted qualified education expenses are now $3,100 ($5,100 – $2,000).

We need to calculate the taxable portion of the distribution. We’ll need to calculate the percentage of the distribution used to pay the adjusted qualified education expense.

So we’ll divide the adjusted qualified education expense by the total distribution amount.

Then we’ll take this percentage and multiply it by the earnings to find the amount of earnings that is tax-free.

$800 earnings times $3,100 adjusted qualified education expense divided by $6,000 distribution equals $413.33 tax-free earnings. We’ll round to $413 since we don’t include cents on tax returns.

Michelle will need to include $387 ($800 – $413) in income on line 8 of her Form 1040 as taxable earnings from a distribution from a qualified tuition plan not used for qualified education expenses.

State taxes and contributions to 529 plans

Since each state administers its own 529 plan, state taxability varies.

For example, Idaho allows its taxpayers to deduct up to $6,000 from adjusted gross income each year for contributions to a qualified tuition plan. Montana only allows up to $3,000.

However, some states don’t provide a deduction. California is one of those states.

You can’t deduct contributions to 529 plans on your California state income tax return, even if you invest in a California 529 plan.

Many states have residency requirements to claim a state tax deduction. Check with your specific state for details.

State taxes and distributions from 529 plans

Like federal taxes, distributions from 529 plans used for qualified education expenses are tax-free.

But if distributions aren’t used for qualified education expenses, they may be taxable.

Further, some states don’t recognize qualified education expenses that the IRS allows at the federal level.

Remember Montana? Although the IRS deems up to $10,000 of K-12 tuition a year to be a qualified education expense, Montana doesn’t.

So if you took a distribution to pay for your child’s elementary school tuition in Montana, this distribution would be tax-free at the federal level but you could owe tax on it at the state level.

529 Plan Pros

529 Plan Cons

529 Plans Frequently Asked Questions

• Can I take distributions from a 529 plan to pay my student loans?

  Yes. But you can take no more than $10,000 to pay principal or interest on the designated beneficiary’s qualified student loan. The $10,000 can also be used to pay on a beneficiary’s sibling’s student loan.

• Will a 529 plan affect financial aid?

  Yes. It likely will have an impact on eligibility to receive need-based financial aid.

• I created a 529 plan in Texas. Can the funds only be used for Texas universities?

  It depends.

  Savings plan distributions generally are not restricted to the state where the plan is. They can be used at any university or school, public or private, for qualified education expenses.

  Prepaid tuition plans generally are restricted for use at one of the state’s public universities. For example, Florida’s prepaid tuition plan is good for any of Florida’s public universities.

  The credits purchased in Florida’s plan can’t be used at private universities.
  Since 529 plans are run by states and universities, there aren’t universal rules.

• I received a refund of tuition for a class that I dropped. I paid for this class with my 529 plan. Do I have to pay tax on this refund?

  No, not if you recontribute the refunded amount back to the 529 plan within 60 days.
  If you don’t recontribute it within 60 days, you’ll have to calculate if any of the distribution is taxable.