Getting started with 529 savings plans

College costs have steadily risen over the last 20 years, presenting a substantial financial burden for parents and their college-bound children. According to U.S. News & World Report, the average cost to attend a private, nonprofit institution was approximately $46,600 per year for the 2023/24 academic year, up roughly 40% from 2004. Average tuition to attend a public, four-year, in-state institution increased by 56% over the same period.¹

For parents and their college-bound children who are concerned about sticker shock, putting a funding plan in place is more important than ever. Of course, answering the question, “How does one pay for higher education?” can be complicated, and families will have many options to choose from. For example, some may elect to pay out of current cash flow, while others may choose to utilize financing (i.e., student loans) or leverage nondedicated savings sources. Currently, one of the most popular strategies is to use a tax-advantaged education savings account like a 529 Savings Plan. We examine the potential benefits—and important considerations—of this vehicle below.

What is a 529 Savings Plan?

A Qualified Tuition Plan, or Section 529 Plan, is authorized under Section 529 of the Internal Revenue Code.² These plans are established and run by individual states or state agencies. 529 Plans have many benefits, with the main draw being that they offer tax-free account growth and tax-free distributions toward qualified expenses. Generally, these plans have predetermined investment options, which allow the account owner to invest in a variety of asset classes depending on their risk profile and time horizon.

How to Fund a 529 Plan

When it comes to funding, 529 Plan owners have substantial flexibility. Contributions up to the annual gift tax exclusion ($18,000 in 2024) can be made without any tax implications for the donor, and 529 Plans offer a unique provision allowing a donor to frontload up to five years’ worth of gifts into a single contribution.  For example, a married couple could fund a 529 Plan with $180,000 and incur no gift tax implications ($18,000 x 2 donors x 5 years.) Individuals can contribute above these thresholds but may be subject to gift and estate tax considerations.

While there are no income tax credits or deductions for contributions at the federal level, some income tax benefits can be found at the state level. Other states, including California, offer no such benefits. Fortunately, one does not need to establish a 529 Plan in their home state, though it’s important to note that tax benefits will vary depending on your residency and whether you use your home state’s plan or a plan in another state. 529 Plans have a stated aggregate limit, which also varies on a state-by-state basis.

Using a 529 Plan to Pay College Expenses

In order to make full use of a 529 Plan’s tax-advantaged status, distributions from the plan may only be used to cover certain qualified expenses, which the IRS defines as “tuition, fees, books, supplies, and equipment a designated beneficiary must have to enroll or attend an eligible educational institution.”³ Non-qualified distributions may be subject to income tax and a 10% penalty on the earnings component (plus potential state income tax penalties). Besides qualified higher education expenses, the 2017 Tax Cuts and Jobs Act (TCJA) also allows 529 Plans to fund up to $10,000 per year in K-12 tuition costs. Importantly, not all states conform to the new TCJA provisions yet, and there may be tax implications for using 529 funds for K-12 tuition in those states (for example, in California).

What to do With Unused 529 Funds?

Sometimes, 529 Plans are left with excess assets due to their robust funding capacity and the general capriciousness of trying to save for a variable future expense like education. Perhaps the beneficiary received a scholarship, or decided to leave college early and become an entrepreneur or circumvent the traditional higher education path altogether. In that case, there are a few ways to utilize the saved funds without triggering income taxes and penalties (which comprise ordinary income tax plus a 10% penalty on earnings). Below, you will find some common options:

1. Reassign the beneficiary: The account owner is permitted to reassign the 529 Plan account to another family member of their choosing (another child, niece/nephew, etc.).
2. Rollover funds to a Roth IRA for the beneficiary: SECURE ACT 2.0 allows up to $35,000 to be rolled directly into a Roth IRA for the beneficiary, subject to annual contribution limits and other restrictions.
3. Student Loan Repayment: Up to $10,000 can be used to pay qualified student loan balances, if applicable.

How to Get Started

The rising cost of education has made it abundantly clear that proper planning is vital in cultivating a successful financial plan. These expenses, coupled with certain complexities, require thoughtful consideration. While every family’s situation is different, your Westmount Advisor is here to walk you through the options and strategies available to meet your goals. Contact us by calling 310-556-2502 or emailing info@westmount.com to get started.