529 College Savings Plan: What is it and Why do you need one

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Seems it’s too early to start a college savings plan for your child? Well, they are going to grow up sooner than you think. 

Surprisingly, the student loan debt numbers are staggering and on the rise. The total student debt outstanding in the United States as of 2021 stands over 1.75 trillion dollars with the average amount of student loan debt per borrower at over $40,904. With the cost of higher education only seeming to go up, parents and grandparents should begin contemplating how their children and grandchildren will afford a quality education. 

In the article below, we’ll guide you through some of the key points you need to know when setting up a college saving plan. 

What is a 529 College Savings Plan?

Grants, scholarships, part-time employment while in college, and even beginning at a community college to transfer later, are all ways to help diminish the burden of the costs of higher education. Minimizing the need for taking on what can become wealth-eroding and anxiety-producing student loan debt is vital to any savings plan.

For families inclined to set aside funds in advance, the primary savings vehicle used today is the 529 College Savings Plan.

The legislation includes several benefits to 529 Savings Plans:

  • Federal tax-free withdrawals up to $10,000 per year allowed to pay tuition at K-12 schools. (California will charge a 2.5% tax on the earnings portion of the withdrawal.)
  • Up to $10,000 per beneficiary may be used to pay off student loan debt.
  • Costs associated with apprenticeship programs outside of traditional college and trade schools now qualify for tax-free withdrawals.

Much in the same way 401(k) plans allow for tax-advantaged savings specifically for retirement, 529 College Savings Plans allow for tax-advantaged savings specifically for covering the costs of education. The account funds are professionally managed by investing in mutual funds. 

These accounts have high contribution limits and allow for anyone to contribute. That means parents, grandparents, extended family, or even friends can chip in. The accounts also provide the flexibility to change the beneficiary of the account to a qualified family member.

For example, if one child chooses to attend college but not the other or if one child attends college now with another to begin at a later date. For those focused on gifting strategies in their estate plan, a 529 may accept up to five times the annual gift tax exclusion amount. In other words, parents and grandparents may make a lump-sum contribution of $75,000 each to the account without affecting their lifetime gift tax exclusion.

You may also be interested in 10 myths about college savings plans


529s and Planning for College: What You Need to Know

What are the tax advantages? Contributions accumulate earnings on a tax-deferred basis and withdrawals are both federal and state tax-free if the money is used for qualified education expenses. 

What are qualified educational expenses? Withdrawals from a 529 account may be used to pay tuition, fees, room & board, books, and supplies at any accredited college or graduate school in both the United States and abroad.

What if my child uses the funds for something else or receives a scholarship? If the child uses funds for something unrelated to college, then the earnings portion of the withdrawal is subject to both Federal and state taxes as well as a 10% penalty fee (and a 2.5% state penalty fee in California). For children receiving scholarships, they can withdraw the amount covered by the scholarship from the 529 accounts and are only subject to taxes on the earnings portion of the withdrawal (penalties are waived).

Does investing in a 529 plan impact my child’s financial aid eligibility? Every educational institution treats your assets held in a 529 account differently. This also depends on the state where you invest. However, investment in a 529 plan for college usually impacts a student’s eligibility for need-based financial aid. 

For instance, if you are investing in a 529 plan for your child’s higher education, you need to consider how this affects the financial assistance they receive in elementary or secondary school tuition. Many families use a big portion of their financial aid package to pay off ongoing loans. Hence, the more you keep aside for school, the less debt you may have to incur for their education later. 

How much contribution can I make? The best thing about a 529 plan is that it has no contribution limits. But you might want to consider a few things while making a larger contribution. For instance, if your contribution is more than the annual gift tax exclusion, i.e. $16,000 in 2022, then this gets considered against your lifetime estate and gift tax exemption. This comes to $12.06 million as of 2022. 

Moreover, each state has its aggregate contribution limit ranging from $235,000 to $550,000. This amount is fixed based on the price of attending an expensive institution and graduate program. It also considers miscellaneous expenses for textbooks, boarding rooms, etc. 

Pro-tip: Aim to save about one-third of your child’s projected college cost, assuming you can pay off the remaining two-thirds with your current income, student loan and any scholarships they receive. Read more about how you can plan for investing in your child’s future. 

Are there any restrictions that apply to me when I invest in a 529 plan?

You are less likely to face any restrictions on any 529 plan. But we recommend that you go through the plan’s offerings carefully to understand it. You can also consult your financial advisor, who can help you understand and get comfortable with any restrictions that may apply. Here are some things to consider while investing and withdrawing from a 529 plan. 

  • Investments: There are some pre-set investment criteria for an education savings plan. Some restrictions may apply when you want to switch to other options. Under the current tax law, if you’re the account holder, then you can change your investment option not more than twice per year or when you change the beneficiary. 
  • Withdrawals: You can only withdraw your invested money for qualified higher education or tuition for elementary or secondary schools from a 529 savings plan. In this case, you’re not liable for any taxes or penalties. However, some limited exceptions may apply. 

Prepaid Tuition Plan vs Education Savings Plan

Prepaid Tuition Plan

  • The account holder can purchase units or credits at participating colleges and universities at current prices for the beneficiary’s future tuition fees.
  • Prepaid Tuition Plans cannot be used to pay for miscellaneous expenses like future room and boarding. It also does not allow you to prepay tuition for elementary and secondary schools.
  • Most prepaid tuition plans are sponsored by state governments. These include residency requirements for the beneficiary.

Education Savings Plan

  • One can open an investment account to save for the beneficiary’s future qualified higher education expenses. This plan includes the beneficiary’s tuition, mandatory fees and room and board.
  • Withdrawals from this plan can be leveraged at any college or university. Sometimes this also includes non-U.S. colleges and universities.
  • One can pay up to $10,000 per year per beneficiary for tuition at any public, a private or religious elementary or secondary school with an education savings plan.  

529 Savings Plan: An Example

Let’s review an example with a child who skips college and is earning an adjusted gross income of $50,000 (Child A) and a child who receives $50,000 in scholarship funds (Child B) yet both withdraw $50,000 from a 529 Account to pay other expenses.

Child A: travels and enters workforce (child A has an AGI of $50,000)

Withdrawal for non-qualified expenses:

Non-qualified expenses

  • $15,000  used to travel
  • $35,000 Used to buy a car

$50,000 withdrawn by student for other expenses

  • 70% is return of contributions
  • 30% is subject to taxes and penalties

$6570 total taxes and Penalties

$15,000 earnings

  • $1500  – 10% Federal Penalty
  • $375 – 2.5% California Penalty
  • $3300 – 22% Child’s Fed Tax
  • $1395 – 9.3%  Child’s State Tax

$6570 total taxes
Amount received by child: $43,430

Child B: full-time student on scholarship (child B has zero AGI in school

Withdrawal when receiving a scholarship:

Expenses covered by scholarship:

  • $15,000  used to travel
  • $35,000 Used to buy a car

$50,000 withdrawn by student for other expenses

  • 70% is return of contributions
  • 30% is subject to taxes and penalties

$6570 total taxes and penalties

$15,000 Earnings

  • Federal Penalty Exempt
  • California Penalty Exempt
  • $1800 – 12% Child’s Fed Tax
  • $300 – 2%  Child’s State Tax

$2100 total taxes
Amount received by child: $43,430

How to Open a 529 Plan

It is never too early to start a 529 plan to maximize the advantage of the compounding interest. 

Step 1: Choose the most suitable plan

You need not necessarily invest in your state’s 529 plan. Several states offer an income tax deduction or tax credit on contributions to your state’s 529 plan. You can start by looking into a 529 plan performance, understand the fee structure and collect as much information as possible about the different options. Once you have decided on a plan, log into the plan’s website, enter your information, add your beneficiary and you’re good to go. 

Step 2: Start funding your account

Once you’ve decided how much monthly contribution you’d like to make for our child’s college education, you can automate this process. Several plans let you get started with $25 per month.

Step 3: Select your investments

The best way to choose investments is to opt for an age-based portfolio corresponding to the beneficiary’s age. Many plans let you take a DIY approach, and you can choose from a target-risk or individual portfolio. Even if you take one approach over another (individual portfolio vs age-based), you can still change the investment option during each calendar year.

Step 4: Make a withdrawal at the right time

Once the beneficiary has made a decision, it’s easy to make a withdrawal of the money you’ve saved. It’s wise to calculate the amount of money your child will get from a scholarship or grant and then subtract that from the amount you plan to withdraw from your education savings plan. The next step is to contact your plan administrator and submit a withdrawal request form to receive checks. 

UGMA or UTMA for goals outside of college?

A secondary savings vehicle used by families allows for saving not only for college but also other expenses you may wish to plan for in advance.

The Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA) allow for the creation of accounts with very similar features. These accounts allow you to make irrevocable gifts to a minor without establishing a formal trust. Anyone may contribute assets to these accounts and the account may invest in stocks, bonds, and other securities. 

UGMA or UTMA: What’s the difference?

No need to get these confused. There are differences between the two accounts worth considering, but they are minor (no pun intended!). The key difference is that a UTMA may hold real estate or limited partnership interests where the UGMA cannot.

The custodian (you or someone you designate) controls the assets in the account for the benefit of the minor and may spend money on behalf of the minor. The only restriction is that the funds may not be spent on expenses deemed to be “parental obligations” like food, clothing, or shelter. 

Typical uses for these accounts include saving for a first car, first home purchase, wedding, college, business startup, etcetera. When the minor reaches the “age of majority” the custodianship ends and the minor gains complete control of the funds.

What is the age of the majority? It varies by state and is usually 18 years old. However, for California residents, you may select the custodianship to end at age 25 for both types of account.

What are the tax advantages? UGMA and UTMA accounts allow the first $2,200 (for 2021) of investment income generated by the account to be taxed at the child’s tax rate (known as the “kiddie tax”). The kiddie tax rules apply until age 17 or until age 24 if a full-time student. Amounts over $2,200 are taxed at the parents’ tax rate.

It should go without saying that these are not the only ways to set aside money for future college expenses or gift assets to children. These are only account-specific options available to approach those goals. Many investors may also consider Coverdell ESAs, traditional investment accounts, Roth IRA contribution withdrawals, 401(k) loans, home equity loans, or the establishment of trusts as part of their college financing strategy.

The best approach to reviewing how you pay for college or other expenses for your child is to set aside time with your financial advisor and discuss what options best match your investments with your savings goals. Every solution differs based on your asset mix and your child’s education goals.

Consider the investment objectives, risks, charges and expenses before investing in a 529 College Savings Plan. Investments in a 529 plan are neither insured nor guaranteed and there is the risk of investment loss. This material is not intended to be construed as tax or legal advice. Always consult your tax and/or legal professional for details regarding your specific situation.

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Are you ready to invest in your future? Consult Capital Growth Inc, San Diego’s financial experts, to set out on your personal plan towards financial freedom.


Consider the investment objectives, risks, charges and expenses before investing in a 529 College Savings Plan. Investments in a 529 plan are neither insured nor guaranteed and there is the risk of investment loss. This material is not intended to be construed as tax or legal advice. Always consult your tax and/or legal professional for details regarding your specific situation.

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