A 529 plan is a type of investment account in the United States. This type of plan is popular among individual investors because it offers significant tax savings when the included investments are used for qualified educational expenses. In this way, individual consumers are able to save for education without worrying about tax penalties. Unlike more general, national investment plans such as 401ks--which offer federal tax protection--529s are typically sponsored by a state and offer state tax benefits. Knowing set up a 529 plan and take advantage of its tax-saving features can help you save money now and for future education-related expenses.
History
The creation of the 529 investment plan was originally started by the United States Congress in 1996 under the Small Business Protection Act. A year later, the act was modified and the education-related portion was given more detail in the 1997 Taxpayer Relief Act. Since then, each of the 50 states in the U.S. have created 529 investment plans for state residents. The actual term "529" refers to section 529 of the Internal Revenue Service's revenue code. This legally establishes "a qualified tuition program" that is "exempt from taxation."
Significance
The creation of the 529 plan has changed the way in which families prepare to cover the cost of college tuition for their children. Before the founding of the 529, families had limited options when it came to saving for upcoming school expenses. Most of these savings were taxable, decreasing the total amount being saved for education. The 529 investment plan offers significant savings for individuals preparing to pay for a beneficiary's future education expenses out of such savings. Under IRS guidelines, these savings are exempt from taxation when used for qualified school expenses. Thus, individuals can deduct a large amount of money on their year-end tax return by depositing a portion of their income into a 529 plan--thereby effectively lowering the amount of state income tax owed.
Types
There are two types of 529 investment plans: prepaid tuition plans and college savings plans. Prepaid plans are usually sponsored by specific state governments and require the beneficiary of the account to live in the state. The value of the savings are adjusted for inflation and can be applied to state schools, much like a voucher. On the other hand, college savings plans work similar to mutual funds with age-adjusted risk levels. Students may withdraw money from the 529 tax-free so long as they are applied toward qualified educational expenses.
Identification
Identifying what counts for qualified educational expenses under a 529 plan is essential for avoiding a tax penalty. Funds withdrawn from a 529 plan may be applied toward the cost of tuition and school fees, books and any other supplies required by an accredited U.S. school. Money from a 529 can also be applied to cover the cost of room and board, including off-campus residences. Exceptions may be made in extraordinary circumstances, such as the death of the beneficiary.
Benefits
The main benefit of 529 plans is that most states offer income tax deductions to cover the value of money deposited into a 529 investment account. Such tax savings help to encourage families to save without having to worry about any tax penalties. The deposited money then matures in value until funds are withdrawn. A secondary benefit is that the donor still technically owns the money, and the student toward whom the account is for cannot access the money except for qualified expenses.
Warning
Discuss with a tax adviser how a 529 plan can be incorporated into your financial budget. While 529 plans offer significant savings for investors saving for future education expenses, there are several pitfalls that may affect investors. For example, withdrawn money that is not applied toward qualified expenses is not only taxable, but it's also hit with an additional 10 percent tax fee. Also, these educational investment accounts count as a financial asset on the Free Application for Federal Student Aid (FAFSA) and thereby decrease a student's chance of receiving need-based aid.
Tags: applied toward, educational expenses, investment plans, qualified educational, qualified educational expenses