529 Plan

Last Updated :

21 Aug, 2024

Blog Author :

Wallstreetmojo Team

Edited by :

Ankush Jain

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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What is a 529 Plan?

529 plan is an educational investment plan through which parents or grandparents can save money for their child or grandchild and can save tax by investing in this plan, as there is no tax levied until the money stays in the account or is used for payment of qualified educational expenses.

529 Plan

It is a and investment plan. It is beneficial for education seekers, whether it be primary, secondary, or higher secondary education. The aims to provide basic education to all. For that, the administrative authority of the plan makes the schemes invest in the plan to minimize future educational expenses.

Table of contents

How Does 529 Plan Work?

The 529 plan caters to US citizens with age equal to or greater than 18 years with legal ID and address proof can open the account for themselves or the beneficiary. The details of the beneficiary are also to be provided at the time of opening an account.

There are two types of 529 plans investment plans and a pre-paid plans. The investment plan allows investing in selected schemes and withdrawal for payment of qualified educational expenses, and withdrawal will be tax-free. However, money withdrawal for a purpose other than prescribed can attract tax and penalties. The main drawback of the 529 plan calculator plan is that it is only limited to educational expenses.

An investor invests in the 529 Plan, and then the 529 plan management team invests the funds in safe securities to grow the money. The management will decide on various schemes for investment. An investor can select any scheme and invest the same into that scheme. The growth of money in 529 plans is also tax-free.

The investor can use the money in their 529 accounts for the beneficiary's qualified educational expenses after the prescribed time is over. If the money is used for another purpose, it is subject to tax and a 10% penalty. This plan also allows the investor to pay the requisite fees of the beneficiary at the current cost for future education so that one can complete the beneficiary's education without any financial problems.

History

Let us briefly discuss the 529 plan rules and history through the explanation below.  

  • The 529 plan’s adoption from section 529 of the federal tax code. The plan originated in Michigan – a state in the US. This state began this plan at the ground level by creating a fund by Michigan Educational Trust with a promise that the trust will pay the qualified educational expenses of the beneficiary at any Michigan-recognized college or university upon investing in this fund by a person resident of the state.
  • This plan became famous as it benefited many students, and other states of the US also started adopting this plan at the state level. Subsequently, the US Government recognized the plan and tax benefits given on investment in this plan.

Types

There are two types of this plan that can be calculated through the 529 plan calculator. Let us discuss them through the explanation below.

Types of 529 Plan

#1 - Investment Plan

An investment plan allows the person to open an account under 529 plan schemes and invest any amount in this account, and such investment will be tax benefits. And also, withdrawals from the account are tax-free if the amount is utilized to pay the beneficiary's qualified educational expenses.

#2 - Pre-Paid Plan

A pre-paid plan allows the person to pay the qualified education expenses of the beneficiary to a recognized college or university at the current cost so that the beneficiary does not need to pay in the future and worry about inflation and increased cost of future education expenses.

Limits

This plan has a few sets of limits regarding contributions, tax benefits, and flexibility. Let us understand them through the explanation below.

  • The funds must be used for qualified education expenses. If an individual withdraws money for non-educational purposes, they will face income tax and a 10% penalty.
  • The 529 plan rules have stated contribution limits, which vary by state but typically range from $300,000 to $500,000. Once this limit is reached, they can't make additional contributions.
  • The investment options within a 529 plan are predetermined, so individuals don't have full control over their investment choices. This can limit your ability to diversify your investments as you'd like.
  • Not all states offer the same tax advantages, and fees can vary, impacting their overall returns.

Who Can Open?

Any resident of the US who belongs to any income group can open a 529 plan account to secure future educational expenses of the beneficiary, and the beneficiary can be any person. To open this account, the account holder should be greater than or equal to 18 years of age and shall have a tax identity number, legal ID, and legal address proof of the US. Details of a beneficiary, like age, planned education, legal ID, etc., are also to be submitted to the authority when opening the account.

What Can It Be Used for?

Now that we know the basics, limits, eligibility, and other such factors of the 529 plan calculator, let us discuss the usage through the points below.

  1. Qualified educational expenses of the beneficiary for primary education include tuition expenses for school up to $10,000 each year for each beneficiary.
  2. Qualified expenses of the beneficiary for secondary and higher secondary education include college fees, payments to recognized universities, etc.
  3. One can also use the amount to pay training fees after secondary education.
  4. One can also use the amount to pay expenses like training or learning or participation fees of any educational institution administered by the US educational department.
  5. One can also use the amount to pay private tuition expenses but to a limited extent.

Tax Benefits

These tax benefits vary by state, so it's essential to research the specific advantages offered by your state's 529 plan rules to maximize your savings for education.

  • State Tax Deductions: Contributions to a 529 plan are often tax-deductible at the state level in over 30 states, reducing your state income tax liability.
  • Federal Tax-Free Earnings: Earnings within a 529 plan grow tax-free at the federal level, allowing your investments to compound without capital gains or dividend taxes.
  • Tax-Free Withdrawals: When you make qualified withdrawals for education expenses, the earnings are tax-free at the federal level, ensuring that you don't pay additional taxes when using the funds for education.
  • State-Specific Benefits: Some states offer additional benefits, such as state income tax deductions for contributions or matching grant programs, making 529 plans even more advantageous for residents and, in some cases, non-residents.

Advantages

Let us understand the advantages of 529 plan calculator through the explanation below.

  1. Financial assistance for qualified educational expenses.
  2. Reduced stress about future costs or inflation.
  3. Tax saving advantage on investment.
  4. Tax-free income on the growth of an investment.
  5. Anytime withdrawals are permitted.
  6. No fixed contribution limits any amount that one can contribute.
  7. One can change beneficiaries.

Disadvantages

A few disadvantages of the 529 rules are as discussed below.

  1. The benefit of the plan is limited only to qualified educational expenses.
  2. Higher penalties on a withdrawal from the account for a purpose other than prescribed.
  3. It does not consider areas other than education.
  4. Sometimes prove to be costly investments as the return on investment is limited.
  5. Investment schemes of the plan have limited investment options.
  6. It results in money blockage as one cannot use the money for other emergencies.

529 Plan Vs Coverdell

Although both these plans primarily focus on savings towards education, there are a few differences that shall be cleared through the comparison below.

529 Plan

  • Contributions grow tax-free. Withdrawals for qualified education expenses are tax-free at the federal level.
  • Some states offer tax deductions for contributions.
  • Typically, high contribution limits, ranging from $300,000 to $500,000, depending on the state.
  • Investment options are limited to predefined portfolios and choices determined by the specific plan.
  • No age limit for using the funds, making them suitable for higher education expenses.

Coverdell ESA

  • Contributions grow tax-free. Withdrawals for qualified education expenses are tax-free at the federal level.
  • Notably, Coverdell ESAs allow for tax-free withdrawals for K-12 education expenses.
  • Contributions are limited to $2,000 per beneficiary per year, suitable for smaller education savings goals.
  • Investors have more flexibility to choose their investments, similar to a traditional brokerage account.
  • Funds must be used by the time the beneficiary reaches age 30, making them more suitable for K-12 and early college expenses.

Recommended Articles

This article is a guide to What is a 529 Plan. Here we explain its history, types, tax benefits, advantages, and disadvantages and compare it with coverdell. You can learn more about it from the following articles: -