The 529 college savings plan allows after-tax investment to grow and be withdrawn tax-free for qualified education-related expenses.
The state-run 529 plans are the newer and better version of the ESA Coverdell plans offered by private brokerage firms. Here are the key features of the 529 college savings plan.
Tax Benefits: 529 plans have Roth-like features, whereby the after-tax contributions grow tax-free and the qualified distributions also taken tax-free. A 529 account is a Post-Tax asset, detailed in our blog “Tax Treatment of Investment and Retirement Accounts.” Some states provide a tax deduction for the 529 contribution. Qualified distributions are education-related expenses. The TCJA law allows 529 funds to even be used for K-12 education up to $10K per year per beneficiary. If the distribution is not qualified, then ordinary income tax and a 10% penalty are owed. The plans are usually flexible with change of account ownership and beneficiaries.
Account Limits: There is no income limit to contribute to a 529 plan. There is no contribution limit either, but there is usually an aggregate account value limit of $235 – $529K that is loosely tied to the college attendance costs. The college costs are summarized in our blog “College Costs and University Endowment Model.” Deciding how much to contribute to a 529 plan is a bit tricky, since it is difficult to forecast what types of financial aid the child will qualify for in the future. Please refer to “Types of Financial Aid” for an overview of Government-sponsored need-based grants and loans.
Account Types: Generally, there are two account options, a Savings Plan and Prepaid Tuition. The Savings Plan is a typical investment account but with limited choices, such as prepackaged goal-based funds provided by the plan administrator. In case of Prepaid Tuition account, the public in-state tuition is covered after making a set contribution amount for a period of time.
Example Scenario: An investment plan (assume 6% CAGR, or Compound Annual Growth Rate) whose target is to satisfy 50% of the inflation-adjusted public in-state college costs (assuming the rest will be covered by financial aid) will need a monthly contribution of $250 until the children are in their sophomore year of college.
Let us next look at the ESA Coverdell plan highlights.
Tax Benefits: The tax benefits are similar to 529 plans. However, only college expenses are considered qualified. The funds must be used before the beneficiary turns 30.
Account Limits: Only individuals with a MAGI <$110K are eligible to contribute and only up to $2000 per year. Contributions can only be made until the beneficiary turns 18.
Account Types: Savings Plan is available through brokerage firms. Investment choices are much broader as compared to a 529 plan.
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