Top 5 reasons to use a 529 savings plan

From federal tax-free earnings to estate planning strategies to special gifting elections, here is a list of the top 5 reasons why 529 savings plans remain the best way to save for higher education. (These benefits may not apply to prepaid plans.)

1.  Federal and state tax benefits

While contributions to a 529 savings plan are made with after-tax dollars, account earnings grow tax-deferred.  This allows your account to grow faster as tax-deferred earnings compound over time.  Plus, earnings come out tax-free at the federal level if 529 funds are used for qualified education expenses.  Additionally, many states offer their own tax benefits for 529 contributions and qualified withdrawals.   

2.  529 funds can be used to pay for qualified expenses at virtually any accredited school in the nation.

Students can use 529 funds to pay for qualified education expenses even if the student attends a college in a different state than the one which sponsored the plan.  For example, your child living in California can be the beneficiary of a New York plan, and attend a qualified school in Florida.

Qualified schools include vocational and trade schools, too.  According to the IRS, eligible educational institutions include "virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions."

3.  Qualified education expenses included more than just tuition

Funds from a 529 plan can be used to pay for the following school expenses:

  • Tuition and fees

  • Books, supplies, and equipment

  • Educational software and computer technology—such as laptops—if required by the school

  • Expenses for special needs services or equipment in connection with attending school

  • Room and board, as determined by the school's "cost of attendance" calculations (amount varies from school to school). Also, student must be enrolled at least half-time. 

4.  Contributions made to a 529 plan are transferred out of the donor’s estate

Money contributed to a 529 savings plan, where the beneficiary is someone other than yourself, is transferred out of your taxable estate.  In addition, assets in a 529 plan generally pass to the beneficiary outside of probate. 

It gets even better.  You can have your cake and eat it too, because while 529 assets are transferred out of your estate, you don’t lose control of the assets as the account owner.  This makes 529 savings plans great for those who can’t bear the thought of making irrevocable contributions.  As the account owner, you direct the investments, and you can revoke the assets if you so choose (taxes and a 10% penalty on the earnings may apply on non-qualified withdrawals).

5.  Large sums of money can be gifted through 529 plans                   

Contributions to 529 savings plans are treated as gifts.  Under normal gifting rules, single filers can contribute (gift) up to $13,000 ($14,000 in 2013) and joint filers up to $26,000 ($28,000 in 2013) to any number of individuals and not incur federal gift taxes.

However, 529 savings plan offer a unique gifting option called a “five-year averaging election.”  If you exercise this option, you can contribute, in a single year, up to five times your annual gift tax exclusion to a 529 savings plan and then elect to treat the contribution as if it were made over the next five years.  This allows individuals to quickly transfer up to $65,000 (and the growth of that money) out of their estate.     

Here is an example –

Jack and Jill sold their water transportation business in 2012.  They received a large lump sum of cash and would like to contribute a large portion of it to their three kids’ 529 savings accounts.  As a married couple filing jointly, they can contribute today up to $130,000 ($26,000 x 5 years) to each of the kids’ 529 savings account, and choose to prorate the gifts from tax year 2012 to tax year 2016.  In total, they can gift $390,000 between their three children in 2012 and not be required to pay federal gift taxes or deduct it from their Unified Credit.

Keep in mind, however, that since they maxed out their tax-free gifts to their kids for the next five years, they will not be able to make any further tax-free gifts to them during that time.

The benefits of 529 savings plans don’t end here.  Other benefits include making annual investment changes, ease of reporting and record keeping, ability to change beneficiaries, and no income limits, just to name a few.   

Disclosure: Each person's situation is unique and 529 plan rules and restrictions may vary depending on your individual circumstances. Consult your financial advisor and/or tax accountant.