According to the annual 529 Plan Awareness Survey by the financial investment firm, Edward Jones, two-thirds of Americans don’t know what a 529 plan is. (Hint: It is a tax-advantaged way of saving for college.)
So, there are undoubtedly many things that most people don’t know about 529 college savings plans. In celebration of National College Savings Day on May 29 (5/29, get it?), here are five things that even the one-third of Americans who could correctly identify a 529 plan as a college savings plan might not know.
You can still contribute to a 529 plan even if the student is already enrolled in college.
There is no age limit on contributions to 529 plans. If there’s money left over, the 529 plan can be used to pay for graduate or professional school or for the college education of a relative.
There is an added benefit for taxpayers who live in one of the 35 states that offer a state income-tax deduction or credit on contributions to the state’s 529 plan. These taxpayers can use contributions to the 529 plan as a way of getting a discount on tuition and other college costs at the taxpayer’s marginal state’s income tax rate. Instead of paying the college bills directly, these taxpayers first contribute the money to the state’s 529 plan to qualify for the state income-tax benefit and then take a qualified distribution from the 529 plan to pay for college. Note, however, that some states base the state income-tax benefit on contributions net of distributions, in which case, the taxpayer must make a contribution one year and take the distribution the next year, staggering the contributions and distributions in every other year.
The impact on eligibility for need-based financial aid is minimal, if the 529 plan is set up correctly, yielding only a slight penalty for savings.
If the 529 plan is owned by a dependent student or the dependent student’s custodial parent, the 529 plan is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA) and qualified distributions are ignored. A portion of parent assets are sheltered on the FAFSA. The remaining reportable parent assets are assessed on a bracket scale of up to 5.64% of the net asset value. That means that for every $10,000 in a 529 college savings plan, the family will net at least $9,436 to pay for college costs. When parents save for their children’s college education, they increase opportunities for the student to choose a more expensive college and/or reduce the amount of educational debt at graduation.
In contrast, if a 529 plan is owned by anybody else, such as a grandparent, aunt, uncle or other relative, the 529 plan is not reported as an asset on the FAFSA, but qualified distributions count as untaxed income to the beneficiary. This can reduce the student’s eligibility for need-based financial aid by as much as half of the distribution. For example, for every $10,000 in a grandparent-owned 529 plan, the family will net at least $5,000 to pay for college costs.
Incidentally, if the student’s parents are divorced and the 529 plan is owned by the non-custodial parent, it is treated the same as a grandparent-owned 529 plan, hurting eligibility for need-based aid. Thus, it is better to have the 529 plan owned by the custodial parent.
Rebates earned through Upromise and other loyalty programs can not only be swept into a 529 plan before college, but the rebates can also be used to pay down education debt after the student graduates.
The IRS won’t let you double dip. Qualified higher education expenses cannot be used to justify both a tax-free distribution from a 529 plan and the American Opportunity Tax Credit (AOTC). Since the AOTC provides more financial value per dollar of qualified higher education expenses, families should maximize the tax credit, if eligible, before taking a tax-free distribution from a 529 plan. Since the maximum $2,500 tax credit is based on $4,000 in qualified higher education expenses, families should plan on carving out $4,000 in eligible expenses each year to be paid for in cash or with loans.
Children with 529 plans are more likely to enroll in college. Setting up a 529 plan after a child is born creates an expectation that the child will eventually enroll in college. This influences the student’s academic choices and academic performance, encouraging the student to take more rigorous courses and helping the student to get better grades.