[Edited 2019/05/30 to
- clarify that you are allowed to open an investment 529 with any state,
- rearranged the order of some sections
- link to my post on gift taxes
- add section explaining that only the gains are subject to tax and a 10% additional penalty if you withdraw 529 money for non educational expenses
- add section about not being able to deduct losses in 529s (which will become available again in 2026 barring changes to the law]
When Should You Not Use a 529?
First and foremost, the first tool in your arsenal to tackle the cost of college should never be the 529. Scholarships, dual enrollment, taking a bunch of AP and/or CLEP exams, or an alternative to college (such as trade schools, certification for free online courses, etc) should all be prioritized above saving in a 529 plan.
Secondly, if you are not maxing out your retirement accounts ($18,500 for 401(k), 403(b), and 457(b) plans at this time of writing), you should not even consider saving for your kid's college costs. Your kid can always get a loan for college, but you cannot get a loan for retirement .
The biggest problem with using 529s is psychological: it sets you down a path of college is a large expense I have to save for, as opposed to the path of how can I actually reduce or possibly eliminate the cost of college?
All that being said, 529 plans are just a tool - they can be used well or poorly.
What is a 529?
The 529 (otherwise known as a Qualified Tuition Program (QTP)), gets its name from being born out of section 529 of the tax code. All 529s are offered by state governments.
There are actually two different types of 529 plans, of which almost this entire post will be dedicated to the investment type. But there are prepaid 529s, where you pay for future college tuition today. The big disadvantage of these prepaid 529s is that these prepaid credits are only good at the universities of that state. If you're okay with this limitation, prepaid 529s may be a good deal (but I have done almost no research into them so I really can't say). There is a way to back out of this by either transferring or refunding the money in the prepaid 529, but apparently your growth of your funds is limited.
The other type of 529 is an investment account that operates like a college expenses Roth IRA at the federal level. You put money in post federal tax and invest it in the options available. Many 529s are mediocre, charging large fees on top of the expense ratio of the underlying funds. However, there are several good 529s, such as that of New York, Nevada, Utah, Ohio, and California (more on California later). If the money is withdrawn for college expenses, then any investment gains are not taxed. On the other hand, if the money is withdrawn for any other reason, the investment gains (not your initial contribution) are not only taxed but subject to a 10% penalty.
Oftentimes states will offer a deduction (typically between $2000 and $10,000) or credit for their state income taxes if you contribute to their 529 plan. This can sometimes offset the mediocre funds offered in the 529 (or you may be able to rollover the funds - more on that later). You can check here to see if your state offers a deduction or credit.
Unlike UTMA or UGMA accounts, the 529 account owner always retains complete control of the money. He or she decides when to withdraw the money on the behalf of the beneficiary (student).
So without further ado, I present to you your guide to 529 plans.
You Can Use Any State's Investment 529
While you usually (always?) have to be a resident of that state to use their prepaid 529, you can open an investment 529 with any state. In general, if your state offers a tax deduction or credit, you should strongly consider using your state's 529 plan (I have an upcoming post on when your state's expensive 529 plan may not be worth using despite the tax deduction or credit).
On the other hand, if your state does not offer a deduction or credit, you should look at 529s from the states mentioned earlier.
Don't Necessarily Skip Your State's 529 Plan Because it has High Fees
If your state has expensive funds in their 529 plan, but offers a tax deduction or credit, it may still be possible to get the best of both worlds. Some states do not recapture the deduction or credit if you rollover your money from their 529 plan to another state's 529 plan. A listing of whether each state recaptures rollovers or non-qualified withdrawals (read carefully) is provided here, though I would certainly double check with your state's documentation before proceding.
So, if your state offers a 529 deduction or credit, doesn't recapture rollovers, but has terrible funds, then the financially optimal approach is to contribute to your state's 529 and then rollover the money to a different 529 plan that has cheap index funds. This does add some paperwork, so it depends how much your deduction or credit is as to whether this is worth your time. There is one state (Pennsylvania) that gives you a deduction for a contribution to any state's 529, so you don't have to deal with this nonsense.
Beware of the Credit/Deduction Recapture
This was mentioned briefly in the previous section, but some states will recapture your deduction or credit for contributions if you don't use that money for QHEEs (Qualified Higher Education Expenses). Recapturing a deduction means adding back a previous deduction to the current year's taxable income. Recapturing a credit means adding back a previous credit to the current year's tax liability.
529s Are Not Just Investment Vehicles, but also Coupons for College
I go into more detail about this in a prior post, but the gist of it is in most states you can contribute to a 529, withdraw the money immediately, and get the deduction (assuming your state offers one). By funneling money through your 529 you can save yourself money for college.
However, you do have to be careful: some states will only let you deduct your net 529 contribution for the year.
I do this every year to save $120 on my taxes (I'm a graduate student).
You Can Open a 529 for Yourself
I have a one, which I use for the coupon method described above.
Unique to 529s, Room and Board is a Qualified Expense
There are several educational tax benefits (such as the American Opportunity Tax Credit, the Lifetime Learning Credit, the Tuition and Fees deduction, and the traditional IRA early withdrawal penalty avoidance), but they don't necessarily have the same definition of Qualified Higher Education Expenses (QHEE). IRS Publication 970 explains that for 529s, if a student is enrolled at least half time,
These are expenses related to enrollment or attendance at an eligible postsecondary school. As shown in the following list, to be qualified, some of the expenses must be required by the school and some must be incurred by students who are enrolled at least half-time, defined later.
The following expenses must be required for enrollment or attendance of a designated beneficiary at an eligible postsecondary school.
- Tuition and fees.
- Books, supplies, and equipment.
- Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible postsecondary school.
- Expenses for room and board must be incurred by students who are enrolled at least half-time (defined below).The expense for room and board qualifies only to the extent that it isn't more than the greater of the following two amounts.
- The allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
- The actual amount charged if the student is residing in housing owned or operated by the school.
- You may need to contact the eligible educational institution for qualified room and board costs.
- The purchase of computer or peripheral equipment, computer software, or Internet access and related services if it's to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible postsecondary school. (This doesn't include expenses for computer software for sports, games, or hobbies unless the software is predominantly educational in nature.)
Half-time student A student is enrolled “at least half-time” if he or she is enrolled for at least half the full-time academic work load for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled.
[Emphasis added to "greater"]
The key here is that unless you live on campus, the amount that the student spends on housing does not matter. The 529 account owner is always allowed to make qualified withdrawals in the amount listed by the student's school as the room and board portion of the cost of attendance.
For example, as of this writing, at the University of Maryland, the estimated off campus room and board expenses total $14,318 (and the on campus expenses are $12,428). Even if the student is a resident advisor (which in (almost?) all cases means free housing), $12,428 can be withdrawn from a 529 without taxes or penalties. Similarly, even if the student lives off campus for free because he or she bought a place and is renting out rooms, covering the mortgage and utilities, $14,318 can still be withdrawn from a 529 without taxes or penalties. The amount spent on room and board does not matter (unless you live on campus and are charged more than the cost of attendance, but that's probably not the frugal way to live).
If you are using 529 money for room and board, I would definitely save the financial cost of attendance to a PDF every single year to document that your withdrawals are qualified.
Coordinate 529 Benefits with Tax Credits
There are two educational tax credits and one tax deduction: the American Opportunity Tax Credit (AOTC), the Lifetime Learning Credit (LLC), and the Tuition and Fees deduction. You can only claim one of these per student per year. For undergrads, the AOTC offers the largest benefit, so I will assume without loss of generality the AOTC is being claimed for the rest of this section.
Per IRS Publication 970, one cannot claim the same QHEE for the AOTC and qualified 529 withdrawals.
An American opportunity or lifetime learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses aren't used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the credit.
The AOTC is a valuable credit worth up to $2500:
The amount of the American opportunity credit (per eligible student) is the sum of:
- 100% of the first $2,000 of qualified education expenses you paid for the eligible student, and
- 25% of the next $2,000 of qualified education expenses you paid for that student.
So you don't want to mess this up. In order to claim the full AOTC you must pay for $4000 of QHEE (where this definition of QHEE doesn't include room and board) out of pocket. No 529 money. So pay $4000 with outside money, and pay for the rest with 529 money.
What if You Oversave in a 529?
If You Don't Use Your 529 Money for QHEEs, only the Gains are Subject to Tax + 10% Penalty
From IRS Publication 970
Are Distributions Taxable?
The part of a distribution representing the amount paid or contributed to a QTP doesn't have to be included in income. This is a return of the investment in the plan.
The designated beneficiary generally doesn't have to include in income any earnings distributed from a QTP if the total distribution is less than or equal to adjusted qualified education expenses (defined under Figuring the Taxable Portion of a Distribution , later).
Earnings and return of investment. You will receive a Form 1099-Q from each of the programs from which you received a QTP distribution in 2018. The amount of your gross distribution (box 1) shown on each form will be divided between your earnings (box 2) and your basis, or return of investment (box 3). Form 1099-Q should be sent to you by January 31, 2019.
The 529 plan administrator will mail you a form clearly delineating the portion of any 529 distribution attributable to gains so you can properly report any penalties to pay for using 529 funds for non Qualified Higher Education Expenses (QHEEs).
Figuring the Taxable Portion of a Distribution
To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.
Adjusted qualified education expenses.
This amount is the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:
- The tax-free part of scholarships and fellowship grants (see Tax-Free Scholarships and Fellowship Grants in chapter 1);
- Veterans' educational assistance (see Veterans' Benefits in chapter 1);
- The tax-free part of Pell grants (see Pell Grants and Other Title IV Need-Based Education Grants in chapter 1);
- Employer-provided educational assistance (see chapter 11 ); and
- Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
Use the following steps to figure the taxable part.
- Multiply the total distributed earnings shown on Form 1099-Q, box 2, by a fraction. The numerator (top part) is the adjusted qualified education expenses paid during the year and the denominator (bottom part) is the total amount distributed during the year.
- Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Schedule 1 (Form 1040) or Form 1040NR, line 21.
You should first reduce your QHEE by any tax free educational assistance such as fellowships and scholarships. Afterwards, all earnings are distributed pro-rata for all distributions.
To paraphrase the example provided in Publication 970, if you had a $5300 529 distribution, of which $950 are earnings, then 950/5300 = 17.92% of your distribution is attributable to earnings.
If you had $5200 in QHEE, then you have $5300 - $5200 = $100 in "non qualified" withdrawals, of which 17.92% = $18 is subject to both tax (by being added to income) and a 10% additional penalty.
If you had $3000 in QHEE, then you have $5300 - $3000 = $2300 in "non qualified" withdrawals, of which 17.92% = $412 is subject to both tax (by being added to income) and a 10% additional penalty.
Scholarships Don't Force You to Incur Penalties for Oversaving
If the student earns a scholarship, the 529 account owner can withdraw an amount up to the amount of the scholarship, penalty (but not tax) free. Per IRS Publication 970
Additional Tax on Taxable Distributions
Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.
The 10% additional tax doesn't apply to the following distributions.
3. Included in income because the designated beneficiary received:
a. A tax-free scholarship or fellowship grant (see Tax-Free Scholarships and Fellowship Grants in chapter 1)
Exception (3) applies only to the extent the distribution isn't more than the scholarship, allowance, or payment.
529s without Vanguard Funds Aren't Necessarily Bad
California actually offers a couple great funds in their 529. They offer a US stock market index fund with a total expense ratio (ER) of just 0.08%, and a bond fund with a 0.15% ER. But I'd say the overall plan is not so great - their age based funds don't have competitive ERs.
That being said, New York, Ohio, Utah, and Nevada offer 529s with low cost Vanguard funds.
Leave a comment if you find good funds in other plans.
You can Cash in US I and EE Savings Bonds Tax Free into 529s
I and EE Savings bonds are special savings bonds offered by the US government. EE Savings bonds offer a fixed interest rate, but if you wait 20 years, you will get a one time doubling of the bond's value, which is equivalent to a 3.5% interest rate.
I bonds have fixed and variable interest rate components. The variable portion is equal to inflation and is held constant for six months. The total interest rate is the sum of the two components. However, the total interest rate is never allowed to fall before zero (which could otherwise happen in a deflationary environment).
You may elect to either pay the taxes on the interest generated by your bond every year, or defer the taxes until you cash in the bond.
Both of these bonds can be used tax free (as in, avoiding the taxes on the interest accrued from these bonds) for education expenses. Again, from Publication 970,
You may be able to cash in qualified U.S. savings bonds without having to include in your income some or all of the interest earned on the bonds if you meet the following conditions.
- You pay qualified education expenses for yourself, your spouse, or a dependent for whom you claim an exemption on your return.
- Your modified adjusted gross income (MAGI) is less than $93,150 ($147,250 if married filing jointly).
- Your filing status isn't married filing separately.
But if you have EE or I bonds that mature before college expenses become due, then you can drop them into a 529 and still avoid the taxes:
Qualified education expenses.
These include the following items you pay for either yourself, your spouse, or a dependent for whom you claim an exemption.
2. Contributions to a qualified tuition program (QTP) (see How Much Can You Contribute in chapter 8).
529s Shield Income from FAFSA
If you invest in tax efficient assets, the effect of shielding income from FAFSA is not significant, but this is still good to know.
FAFSA, or the Free Application for Federal Student Aid, is essentially structured as a tax on both income and assets. You're expected to contribute up to 5.64% of your assets and up to 47% of your income towards the cost of college. But your assets will likely generate income, which makes it "double taxed" for FAFSA.
Suppose Alice doesn't like giving up the flexibility of her money, and decides not to use a 529. She has $20k of VTSAX in a taxable brokerage account. It throws off about 2% in dividends, or $400 every year.
For the purposes of FAFSA, Alice is "taxed" on the $20k of assets and the $200 of income. So as to not get dragged down into the weeds of FAFSA formulas, let's just assume Alice is "taxed" at the highest rates. Therefore, from owning $20k of VTSAX, Alice is expected to contribute $1128 (5.64% of $20k) + $94 (47% of $200) = $1222 towards the cost of college.
Bob, on the other hand, has decided 529s offer some nice advantages (maybe his state offers a nice tax credit or deduction). He has $20k of VTSAX in a 529. It generates $400 in dividends per year.
For the purposes of FAFSA, there is no income to be "taxed" in this scenario. The income generated within the 529 isn't counted as income - it's just a part of the account balance. So Bob is only expected to contribute $1128 towards the cost of college, not $1222, for a savings of $94 (like I said earlier, the difference isn't significant if you're using tax efficient assets).
Contributions to a 529 Constitute Gifts and May Require a Gift Tax Return
When you contribute money to a 529 plan, you are giving a gift to the beneficiary:
If you contribute to a 529 plan, however, be aware that there may be gift tax consequences if your contributions, plus any other gifts, to a particular beneficiary exceed $14,000 during the year. For information on a special rule that applies to contributions to 529 plans, see the instructions for Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
Per the IRS,
The annual exclusion applies to gifts to each donee. In other words, if you give each of your children $11,000 in 2002-2005, $12,000 in 2006-2008, $13,000 in 2009-2012 and $14,000 on or after January 1, 2013, the annual exclusion applies to each gift. The annual exclusion for 2014, 2015, 2016 and 2017 is $14,000. For 2018, the annual exclusion is $15,000.
In 2018, you can gift up to $15,000 to a donee without having to file gift tax returns. This also means that if you are married, as a couple you can gift $30,000 per donee without having to file gift taxes.
You can find more details about gift taxes here, but in general unless you leave millions of dollars to your heirs upon your death, while you are obligated to file gift tax returns for exceeding the annual gift tax exclusion limit, neither you nor your estate will actually pay any gift or inheritance taxes.
529s Let You Front Load Gifts
There is an exception to the $15,000 gift tax exclusion: you are allowed to front load 5 years worth of gifts at once into someone's 529 plan. From the instructions to IRS Form 709,
If in 2017, you contributed more than $14,000 to a Qualified Tuition Plan (QTP) on behalf of any one person, you may elect to treat up to $70,000 of the contribution for that person as if you had made it ratably over a 5-year period. The election allows you to apply the annual exclusion to a portion of the contribution in each of the 5 years, beginning in 2017. You can make this election for as many separate people as you made QTP contributions.
[The 2017 gift tax exclusion limit was $14,000.]
Granted, that is a lot of money we're talking about. But it's an option (which will require you to fill out Form 709).
Changing the Beneficiary of a 529 Can Incur Gift Taxes
You're allowed to change the beneficiary of a 529 to a different family member. But this may constitute a gift. From 26 US Code § 529
(5) Other gift tax rules
For purposes of chapters 12 and 13-
(B) Treatment of designation of new beneficiary
The taxes imposed by chapters 12 and 13 shall apply to a transfer by reason of a change in the designated beneficiary under the program (or a rollover to the account of a new beneficiary) unless the new beneficiary is-
(i) assigned to the same generation as (or a higher generation than) the old beneficiary (determined in accordance with section 2651), and
(ii) a member of the family of the old beneficiary.
So changing the beneficiary of a 529 from yourself to a child constitutes a gift of the full 529 balance. Changing it to your sibling, parent, etc. doesn't constitute a gift.
If you change it to that of two younger generations, then that constitutes a gift in the amount of the full balance of the 529 and will trigger the Generation Skipping Tax (GST) .
Consider Having Two 529 Plans
This is probably more trouble than it's worth, but it's fun to think about.
Ideally you would save exactly the amount the beneficiary needs for college. Obviously this is nearly impossible. To mitigate the consequences of saving too much, considering using two 529 plans: one for stocks and one for bonds. The 10% penalty for non qualified withdrawals is only assessed on the gains, but the gains are always considered pro rata for every withdrawal (qualified or not).
So for example, assume that Bob has two 529 plans, one of stocks and one of bonds. His stocks 529 has done well, and is made up of $20k in contributions and $30k in gains. His bonds 529 has not grown as much, and is made up of $20k in contributions and $10k in gains. He needs to pay for $60,000 in college expenses. He uses all $50,000 of his stocks 529 and $10k of his bonds 529. Afterwards, there is $13,333 of contributions and $6,667 of gains in his bonds 529, because all withdrawals are considered to be proportionally made of the gains and contributions in the account. Bob has oversaved, and this $20k is not needed for any college expenses. Thus, he decides to make a non qualified withdrawal, and owes taxes and penalties on the gains, which in this case is $6,667.
But if Bob had instead put all this money in one 529, he would have started with $40k in contributions and $40k in gains. He withdraws $60k for college expenses, leaving him with $20k in the 529, of which $10k is contributions and $10k is gains. In this situation, Bob owes taxes and penalties on $10k instead of $6,667.
You Cannot Deduct Losses in 529 Accounts
For tax years beginning after 2017 and before 2026, if you have a loss on your investment in a QTP account, you can’t claim the loss on your income tax return. You have a loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account.
The aggregation rules that applied if you had distributions from more than one QTP account during a year were eliminated for distributions after 2014. For more information, see Notice 2016-13 available at IRS.gov/IRB/2016-07_IRB#NOT-2016-13.
This was a Ton of Information. How Should I use 529s?
Assuming you've understood my misgivings about using 529s mentioned at the beginning of this post, my recommendation is to start by looking at your state's 529 plan. Do they offer a tax deduction or credit? If so, for how much? What are the expense ratios and other costs associated with the plan?
If your state offers a tax deduction or credit, then I'd generally recommend maxing that out. Most states only offer a few thousand dollars in deductions or credits. Granted, your state's 529 might offer terrible funds. If that's the case, check if they recapture rollovers (see section above). If they don't, contribute to your state's 529 and rollover the money to a better plan.
Remember, you can always use 529 money for room and board, even if the student's room and board costs are zero. So long as the beneficiary does actually go to college, that's on the order of $10k-$20k/yr you can pull out of a 529 tax and penalty free.
If your state doesn't offer a tax deduction or credit, then I'd look at different state plans (the Saving for College site has a nice overview).
Overall, I'd probably actually shoot for saving in a 529 about half of what you think college will cost when your student goes to college. Other savings can be supplemented from other accounts (like a taxable brokerage accounts), or you can hope your student gets a scholarship (and then you can withdraw money from the 529 penalty free in the amount of the scholarship, if need be).
Technically there are reverse mortgages, but in order to get one you need to save enough equity in your house to begin with, so you're still saving for retirement first. ↩︎
I don't understand why people seem to prefer screenshots over PDFs. PDFs don't have the limitation of only being able to capture the amount of content viewable on your screen, most browsers will print the url along with the content, and they also usually date it ↩︎