Common Questions About 529 Plans and College Savings

College Lecture Hall 529 Plan QuestionsWith the school year right around the corner, now is a good time to start thinking about college savings.

Have you heard about the 529 college savings plan? Are you curious if you should get started with one?

I’ve had some questions come in lately regarding saving for education expenses using a 529 Plan. I thought I’d take today to attempt to answer a few. Hopefully this will get you more comfortable with the account so you can start funding one for your kid’s college education.

What is a 529 Plan?

A 529 Plan is a savings plan for educational expenses (named after the Federal tax code) set up by individual States or institutions. They’re designed so that you are encouraged to help save for your child’s education (college or trade school). The encouragement comes in two forms: the ability to save money free from Federal taxes and the ability to receive a deduction on State taxes.

The 529 Plan is really the Roth IRA of the college savings world. Meaning, your savings grows tax-deferred and the withdrawals are tax-free as long as you use them for qualifying educational expenses. 529’s are a really good deal.

What About Prepaid vs. Savings Type Plans?

529 Plans usually come in two types: prepaid and savings. It’s important to know the difference. Some States offer one or the other, both, or a plan that combines the features.

Prepaid 529 Plans usually give you more tax benefits and college discount for schools in that particular State. The prepaid plans are considered inflation-busting, since they allow you to save for college at today’s prices.

But they also come with more restrictions. For instance, if you decide to use a prepaid plan in your State and then later send your child to a college out-of-state you’re going to forfeit some of the savings you were able to get by being in an in-state prepaid plan. This varies greatly by State plan.

529 Savings Plans are more flexible. You can usually use these types of plans at any accredited college or university in the Country. I’m a resident of Texas and have a 529 Savings Plan with Ohio’s CollegeAdvantage Program. Since it’s a savings-type plan, I can use the funds where ever I want, as long as it’s for qualifying education expenses.

What if my child doesn’t end up going to college?

The savings and earnings from the savings are always your money. The donor (you) always maintains control over the funds. The beneficiary (your child) has no control. You can switch beneficiaries at any time (typically once a year).

So, if your first kid doesn’t go to a qualifying institution, then you can switch the plan beneficiary to another child, yourself, or whoever. Or, you can withdraw the funds. There is generally no limit to how long keep the funds in the 529 plan account.

The only thing that you may forfeit for not using the funds for educational spending is the tax savings on the funds, and a 10% penalty on the earnings from the savings.

As an example, let’s say:

  • You deposit $50,000 now into a 529 Plan.
  • Fast forward 18 years and your funds are now worth $60,000. You’ve earned $10,000!
  • Let’s assume your child decides to skip college.
  • If you withdraw those funds and use them for yourself on Twinkies, the $10,000 would be subject to the tax and the penalty.
  • You’d roughly owe the Federal Government $3,000 to $4,000. You’d walk away with around $56,0000 of your $60,000.

But, the 10% penalty can be waived if your child  becomes disabled, dies, or gets a scholarship.

What if my child gets a scholarship to college, then what happens to the 529 Plan funds?

Like I said above, you generally have a few options: transfer to another beneficiary and give it to them, sit on the funds until another option becomes available, or withdraw the funds penalty-free (you just have to pay the taxes). The penalty is waived if your child gets a scholarship though.

Should I open a separate 529 account for each child or should I have just one account?

Yes, open an account for each child. To my knowledge you can only have one beneficiary of the funds from an account.

Do I have to use my State’s 529 Plan?

No. But there may be a good reason for you to. Typically the savings in State taxes is the biggest factor. The best guide I’ve found for helping me determine this is Kiplinger’s Best 529 Savings Plans. They will tell you if there’s a reason to stick to your State’s 529 Plan or go with a top 5 plan from another state.

Can you withdraw 529 Plan funds for an emergency with or without pentalty?

Generally, you have complete control over the funds in the plan. You can withdraw your funds at anytime, for any reason. As I mentioned above though, you’d be subject to a tax and penalty on the earning from the savings. There is no hardship rule that I know of that would exempt you from the penalty.

What age or when do you HAVE to withdraw the 529 Plan funds?

There generally is no age or time limit for withdrawals.

Could the 529 Plan act as a nest egg fund for my children?

Using the 529 Plan for anything other than educational expenses would be an inefficient use of the plan. If you’re looking for a place to stash some emergency savings, consider an FDIC insured high-interest savings account.

Should I consult a CPA, CFP, and understand the plan I’m getting into?

This is advised, but it’s not absolutely necessary. If you’re unsure about opening up a 529 plan, please visit a fee only financial professional to understand your full range of college savings options. There are other options like Coverdell ESAs that might be a better for your situation.

Another reason to consider working with a pro is that each State plan and tax implications have an impact on your decision. Lastly, take time to research the plan you’re getting into. Read the guidelines of the plan. Call up your State’s plan administrator and have them explain it to you.

Good luck getting started with your college savings!

Photo by cogdogblog

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  1. CollegeKidsMom says:

    Two questions for you:
    How long must money stay in the plan? For example, can I deposit money on Monday and withdraw it on Tuesday and still claim the state tax credit?
    Do with contributions and withdrawals cancel each other out during any tax year? For example, if I contribute $3000 and withdraw $2000 for tuition, is my contribution for the year $3000 or $1000?

    • Philip Taylor says:

      @CollegeKidsMom Most states don’t stipulate how long the money needs to be in the 529 plan to get credit for the contribution on state taxes. Check with your state plan’s customer service. They should be able to clarify. In your example, your contribution would be $3000.

  2. collegemom1 says:

    My son took a distribution from his 529 plan but it came in my name. He did not use if for college expenses I still have the money. However he has an oustanding student loan. Can he use the money to pay the student loan? If he does will I have to pay the penalty and taxes because the check came in my name?

    • Philip Taylor says:

      @collegemom1 Unfortunately student loan debt is not a qualified education expense, so he can’t use the 529 money to pay off student loans. Regarding the check in your name, I would call the 529 plan administrator and talk to them about who’s name the account should be in. Good luck.

  3. My child passed away last year and I have no other children. Is there a time limit after a child’s death in which a 529 plan has to be closed.

    • Philip Taylor says:

      Sorry for your loss, CBC. To my knowledge a 529 plan never has to be closed based on the status of the beneficiary. It can remain open as long as the account holder (you) is living. I would just leave it alone for a while until you decide your next move with that money.
      You might want to at least call your service provider and tell them about the situation. They will want you to designate a new beneficiary. In which case you will just want to make yourself the beneficiary until you figure our your next move.
      If you do decide to pull the money out and use it for non-education purposes, I would advise you to check with a local CPA about the tax implications and possible hardship withdrawal rules. Good luck.

  4. My oldest son is going to college in the fall of 2012. We just cashed out the 529 to get it ready for college. the checks came today…what do we do with it? how does the plan know we are using it for college, etc? We want to take the right steps.

    • Philip Taylor says:

       @chelling The plan won’t know, and they don’t need to know. Who needs to know is the IRS. The way you tell them is by reporting qualified higher education expenses (QHEE) on your tax return for 2012. Hopefully you haven’t cashed out more than you will use in 2012. If you did, then that money will be considered an unqualified withdrawal and you will have to pay taxes and a penalty on it.

    • Philip Taylor says:

       @chelling I just looked at the withdrawal rules a bit closer and it looks like you can roll some of the money over into a new 529 plan within 60 days and avoid the 10% penalty and tax. Basically, if you took out too much, put it back into a new 529 plan asap. Good luck.

      •  @Philip Taylor  @chelling
         Thank you so much for the info. We only had about $6k in our plan so this will be used up in the first semester of 2012 . I appreciate your response.

        • Philip Taylor says:

           @chelling My pleasure. Great question. Best of luck to you and your son in college. He has wise, generous parents.

  5. I have a 529 plan that my grandparents set up for me before I was born. I’m in my last semester of my undergraduate, and haven’t decided if I want to get my masters yet, but I know there will be money left over. What happens to that money when I’m all squared away? Does my dad get it? Do I get it? We are both listed as beneficiaries, so should I try to talk to him about the leftovers? (He doesn’t like to talk about money, and is reluctant to give up control of it, and thusly, I don’t know much about how I’ve been able to finish school debt-free).

    • Philip Taylor says:

      I’m assuming your grandparents have passed? If so, I would assume your Dad has become the new custodian/trustee of the 529 Plan? You are likely still the beneficiary so the money can only be used for your education expenses unless the beneficiary is changed. And I’m assuming your Dad is now the only one who can make that change.

      I would definitely reach out to your Dad to understand the ownership of the account. Talking about money can certainly be awkward, but it’s important for you and your Dad to start to be able to address these issues as he ages and his money situation becomes more relevant for you.

      • Yes, my grandparents have passed, and my dad’s name is on everything involving that plan, right above mine. I do know that what was left of my brother’s money in his plan was transferred to my account after he graduated, and I know who is listed to take responsibility of the plan if Dad passes away. That’s literally all I know about the account. Thank you for the suggestions, I appreciate your input. We’ll see how this conversation goes 🙂

  6. Yes, you can start without kids. You just need to make the beneficiary yourself, or another family member. And you can switch beneficiaries at anytime. Very flexible. Yes, this can be used for yourself for undergrad and graduate school. Thanks for stopping by, Clayton.

  7. Two quick questions. you can start one of these things before you have kids right? and the other is can you name yourself the beneficiary say if I wanted a masters in 5-10 years? Thanks