6 lesser-known benefits of 529 plans

When saving for a child or grandchild's college education, 529 plans are popular for the tax advantages and flexibility they offer. Earnings grow federal tax-free and, as long as the money is used for qualified education expenses, withdrawals — including the earnings portion of a withdrawal — are federal and often state and/or local income tax-free. Qualified education expensesFootnote ¹ also include:

• Up to $10,000 per year per beneficiary to help pay for tuition in connection with enrollment or attendance at an eligible elementary or secondary public, private, or religious school (state tax treatment may vary)
• Expenses for fees, books, supplies and equipment required for the participation of a designated beneficiary in a registered and certified apprenticeship program
• Payment of student loans up to a lifetime maximum of $10,000 for the designated beneficiary or a sibling of the designated beneficiary (the lifetime maximum applies separately for the designated beneficiary and sibling of the designated beneficiary)

Below you'll find lesser-known 529 plan benefits worth considering as you save for college.

"Often, people mistakenly believe that because a 529 plan account is earmarked for education, it will have a negative impact on financial aid eligibility," says Richard Polimeni, head of Education Savings Programs at Bank of America. "In fact, a 529 plan is treated more favorably in the federal financial aid formula than saving in a child's name through a custodial account, such as an UTMA or UGMA," which are commonly used accounts for minors that are named after the acts that established them: the Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA). That's because assets in a 529 plan are typically owned by a parent, not the child. 529 assets only count as 5.6% of assets for purposes of the financial aid calculations, compared to UGMA or UTMA accounts at 20%.Footnote ² When calculating how much the family is expected to contribute, the Free Application for Federal Student Aid (FAFSA) specifies that assets belonging to parents are tapped at a lower rate than those held in a child's name.

Your straight-A student or basketball star may give you an unexpected gift by earning a "full ride" or substantial scholarship toward college. In those cases, you can withdraw an amount equal to the scholarship from the 529 plan and only pay ordinary income taxes on the earnings portion of the withdrawal. You do not incur the 10% additional federal tax normally required on withdrawals that are not going to qualified education expenses. Consider using that money to help you meet other financial goals, such as saving for retirement.

You also can give those unneeded 529 plan assets to another relative to use for college. It's as simple as changing the name of the account's beneficiary to someone in the 529 designated beneficiary's family — for example, one of your other children or even your child's first cousin — without adverse income tax consequences.Footnote ³

Anyone age 18 or older with a Social Security number or taxpayer identification number who resides in the United States can open and fund a 529 plan account (refer to the state's 529 plan rules to confirm your eligibility). And it can be used at any accredited postsecondary institution, including technical and vocational schools. It can be a great way to start saving for further training for your current career or a new one you are considering.

Every state — and the District of Columbia — sponsors its own 529 plan to pay costs at accredited schools in any state. Many states offer state income tax deductions to residents and taxpayers contributing to their home state's plan. "It's important to consider any benefits available in your home state," says Polimeni, "but you need to evaluate a particular 529 plan's features like you would any other investment. Look at the plan's investment manager, investment choices, plan performance and underlying fees and expenses before you invest."

Contributing to a 529 plan also can help grandparents or others reduce the size of their taxable estates while helping fund a grandchild's education. Each year, you can contribute a certain amount to a 529 plan for each beneficiary without triggering federal gift taxes or using your lifetime estate- and gift-tax exemption. The amounts you can contribute as well as the exemption can change annually. The latest information can be found in our Annual Limits Guide (PDF). While contributions to 529 plans aren't deductible on your federal income tax return, the investments have the opportunity to grow tax deferred, and distributions that go to the beneficiary's qualified education expenses are free from federal taxes.Footnote ¹

It's even possible to accelerate your gifting timetable by contributing five years' worth of annual exclusion gifts per beneficiary to a 529 plan in one year using the annual federal gift tax exclusion. Keep in mind that within the five-year period, you won't be able to make additional gifts to the beneficiary — whether the gift is a contribution to a 529 plan or any other form of gift — without triggering the federal gift tax or using your lifetime gift exemption.Footnote ⁴