Money in a 529 plan grows untaxed and comes out tax-free for school costs, and many states also give you a tax break for putting it in. Before you open one, check whether your state’s break requires its own plan, then set up an automatic monthly contribution.
No other education account stacks those breaks as well. A Coverdell education savings account also grows tax-free, but it caps contributions at $2,000 a year per child and bars contributions above an income limit. A custodial account in your child’s name owes tax on its interest and dividends every year. And because that money belongs to the student, the federal financial aid formula counts 20% of it against aid.
The state break is easy to lose by picking the wrong plan. More than 30 states, counting Washington, D.C., offer a deduction or credit for 529 contributions, and all but nine limit it to their own plan. At a 5% state income tax rate, for example, a $5,000 deduction is worth $250 a year. That can outweigh the lower fees of an out-of-state plan.
Unused money also has more places to go than it once did. Federal rules now let a 529 pay up to $20,000 a year of K-12 tuition and cover career credentials such as a commercial driver’s license or a cosmetology license. Not every state has adopted the K-12 change for its own taxes, so check yours. Once the account is 15 years old, up to $35,000 over the child’s lifetime can roll into their own Roth IRA. Each year’s rollover can’t exceed the Roth limit or the child’s earned income. Earnings spent on anything else owe income tax plus a 10% federal penalty.
Open the account in your own name with your child as the beneficiary. On the FAFSA, the federal aid application, a parent-owned 529 is a parent asset, and at most 5.64% of it counts against aid. A grandparent can open a separate 529 that the FAFSA doesn’t count at all. Then set up an automatic monthly contribution, however small.
Open it the year your child is born, and the account passes the 15-year test for a Roth rollover before high school graduation.
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