Section 529 plans are tax-advantaged investment accounts that allow parents and other benefactors to efficiently save for a beneficiary’s higher education. They offer tax-free growth, tax-free distributions for education expenses and, in some states, a reduction of state tax liability. But they have some disadvantages.
- The variety of investment options available to 529 plans is increasing, but still somewhat limited, especially when compared with trusts.
- The IRS allows just one reallocation of assets per year within a 529 plan, unlike other tax-deferred plans, such as 401(k)s.
- Withdrawn funds not spent on education expenses are subject to income tax plus a 10 percent penalty and may be subject to the recapture of any state tax deductions taken, similar to early withdrawals from a retirement account.
- Even without a 529 plan, individuals may make tax-free gifts of tuition expenses. The 529 plan thus compromises the individual’s ability to deplete his or her estate by using up exclusion allowances for expenses that are not subject to tax in any case.
- Spouses cannot be beneficiaries.
A 529 plan is the best strategy for many, but not for all. Consult with your estate planning attorney to be sure you make the right choice.