What exactly is a 529 account? Are there any tax advantages to opening one for my child? Why do so many states have their own, and is one better than the other?
These are some questions that cross your mind when deciding how to start saving for your child and their future education. This post will try to answer these questions and give you more insight to the advantages of opening a 529 account for your child.
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DETAILS OF A 529 ACCOUNT
A 529 account is a tax-advantage investment strategy designed to encourage saving for your children and their future higher education expenses. These accounts help set money aside and invest it to help the money grow just as quickly as your child does.
The money that is in this account can be used for a variety of qualifying expenses. It can be used to pay for college education, vocational school, post graduate education, Kindergarden-12th grade tuition, and even items such as computers, books, and other educational expenses.
There are also tax advantages when investing in a 529 account. No federal income taxes are due on any of the earnings when you withdraw money from the account to pay for qualified educational expenses highlighted above.
Not only is the account free from federal income taxes when withdrawing money, but it many cases, it is free from state income tax when contributing money to the account.
WHO CAN SET UP A 529 ACCOUNT?
A 529 account is set up by an account owner, usually a parent or grandparent, and must be a US resident that is 18 or older. There are no income restrictions for opening a 529 plan which is why this is such a common method of investing.
WHO GETS THE CASH?
A beneficiary is identified when opening the 529 account. Anyone of any age can be designated the beneficiary, you can even set it up for yourself.
The flexibility of these plans allows the beneficiary to change. If the oldest child decides they don’t want to go to school, or if they get a scholarship and do not need all of the money in the account, the beneficiary of the 529 account can be changed to a sibling, a spouse, or even yourself.
HOW IS THE MONEY INVESTED?
These accounts are usually invested according to an age-based investment strategy or a Target Date Fund which takes into account the level of risk that you are willing to accept. A 529 account with a target date of 2035 means that you anticipate using the money in the account around that year.
As with retirement plans, you are willing to take on more risk in the beginning to see larger returns, however, as you get closer to the target date, such as high school graduation, you want less risk since you will be using that money soon.
Although contributions to the 529 account are not deductible, the earnings grow tax free and the investment gains will NOT be taxed when the money is taken out to pay for the educational expenses.
In addition to the federal tax savings, over half of the states offer at least a partial tax deduction for state income tax advantages. You can claim state tax benefits every year that you contribute to your 529 account.
If you work in a state that offers a 529 account, you should invest in that state’s 529 plan to take advantage of those state income tax benefits.
If you work in New York, and invest into a NY-529 account, you are able to deduct up to $5,000 from your state income taxes. Each state has different rules and regulations, so it is best to look into your state’s 529 plans to get more information.
As a starting point, it is usually best to invest in a state that you work in to receive that state income tax benefit.
Each state has different 529 requirements and regulations. Some states like California and New York have the most relaxed requirements and flexibility which is why these two are the most common accounts that people invest in. Make sure you do some research on your state as well as California and New York before deciding on what state’s 529 plan you are going to invest in.
FINANCIAL AID IMPLICATIONS
The major concern with applying for secondary education is the cost of tuition. Most people rely on financial aid to help subsidize the cost of education.
So how does a 529 account come into play when filling out the FAFSA form (The Free Application for Federal Student Aid) in determining the child’s need?
Student Owned Assets can reduce the aid package by up to 20%. So if your child has a checking account with $10,000, the student will receive $2,000 less in financial aid.
Money in a 529 account, however, will only reduce the need-based aid by a maximum of 5.64% of the asset’s value. That same $10,000 will only see $564 less in financial aid. That’s a significant difference.
A 529 Account is an excellent investment approach in trying to save for you family’s higher education. The significant federal income tax and state income tax benefits, the flexibility in what you can use the contributions and investment gains for, as well as the ability to easily transfer between family members make this an incredible tool to save for your children.
Eugene is a Chemical Engineer with a passion for personal finance and is constantly learning new tricks to make his money work for him. He obtained an MBA part time and hasn’t stopped finding ways to make money, save money, and properly invest money. He currently lives at the Jersey Shore with my wife and two children.