Like many Americans, you may be missing out on significant tax advantages if you’re not using a 529 plan.  But what exactly is a 529 plan? In short, a 529 plan is an investment account with tax advantages used to pay for secondary and higher education expenses. Also known as a “qualified tuition program,” the 529 plan was authorized by Congress in 1996 to encourage saving for future higher education expenses, and it can be one of the most powerful tools to combat the rising cost of education.

To help you better understand what a 529 account is and how the 529 plan can help cover higher education costs, I’ve laid out a few key details below.

Tax Advantages of a 529 Plan
When properly used, the power of the 529 plan as a financial planning tool lies in the tax savings it provides. The 529 plan is one of the only vehicles with investment earnings not subject to federal tax, and generally not subject to state tax, thereby making secondary and higher education more affordable.

For example, parents of newborn baby Charlie open a 529 account and contribute $400 monthly over the course of 18 years. Assuming a 6% rate of return, an investment of $86,400 over 18 years would grow to over $148,000 by the time Charlie enters college at age 18. With the ability to avoid both federal and state taxes, the 529 plan would allow Charlie’s parents to eliminate taxes on $61,600 of investment earnings ($148,000 balance - $86,400 total contributions) to use on higher education expenses.

Types of 529 Plans
There are two main types of 529 plans available to consumers: prepaid tuition plans and education savings plans.

Prepaid tuition plans allow the purchase of future tuition at current prices. Typically only valid at specific colleges and universities, these prepaid plans often have residency requirements for the contributor and the beneficiary.

Education savings plans, on the other hand, provide a more flexible investment account. They can be used for a beneficiary’s qualified expenses, including tuition and room and board at generally any college or university; and up to $10,000 per year, per beneficiary, for tuition at any public, private or religious elementary or secondary school.

In the event that a designated beneficiary doesn’t use all 529 plan assets for qualified expenses, these plans provide the flexibility to designate a new beneficiary (e.g., sibling, grandchild or even a parent) to use the remaining assets.

For more information on qualified expenses and state-sponsored 529 plans, the IRS has provided additional information via the Publication 970 and 529 Plans: Questions and Answers.

Funding Your 529 Plan
Like most savings vehicles, 529 accounts contain a contribution limit. Since 529 plan contributions are considered gifts from an individual to a beneficiary, 529 contributions that exceed $15,000 per person per year, may be subject to gift tax. Furthermore, other gifts from an individual to the same beneficiary will also count toward the annual gift tax exclusion.

That said, the IRS allows large contributions to 529 accounts without triggering the gift tax to grow the account. When using the five-year gift-tax election, a couple could make a one-time gift of as much as $150,000 ($15,000 annual gift exclusion x 5 years x 2 individuals) to “superfund” a child’s 529 plan without gift tax consequences.

To help you make the most of your 529 plan, here are a few tips to consider:

  • Control fees and expenses. It’s important to find a plan that can meet your objectives without costing too much. Countless academic studies show that high fees eat away at returns over time, so make sure high fees are not taking over your returns. For more information on fees and expenses associated with 529 plans, consider visiting FINRA’s 529 Savings Plans page.
  • Take advantage of the way investment returns compound over time by starting to save early. The earlier the better is the rule of thumb for starting a 529 plan. In the previous example, had the 529 account been opened six years later and ended at the same time, the resulting balance would be over $67,000 lower.
  • Plan diligently and read the fine print. Thoroughly research age-based portfolios and other investment options to find the best fit for your individual situation. It is important to note that 529 plans typically have more restrictions than other investment accounts, and assets held in 529 plans will generally impact eligibility to receive need-based financial aid. For more information, visit the SEC’s An Introduction to 529 Plans page.
  • Ensure your 529 funding strategy is consistent with a sound comprehensive financial plan. A common pitfall for saving is prioritizing 529 account contributions over retirement savings. Remember that student loans can be obtained, but no such loans are available to fund retirement. This website has additional resources that can be helpful when incorporating a 529 plan into your financial plan.

While a well-managed 529 plan can be one of the most important tools available to combat the rising cost of education, the planning needed to properly select and manage a plan can be a challenging task. If you need help harnessing the power of a 529 account, consider the value of a CFP® professional’s expertise and experience and find one in your area today.