529 education saving plans just got even better

When it comes to putting money aside for a child's future education, 529 saving plans hit the mark as about the most effective way to do so. Every state offers at least one 529 plan, and Americans have put more than $282 billion into 15 million-plus 529 accounts.

Among the benefits are tax-deferred growth (just like an IRA) and tax-free withdrawals for qualifying education expenses. Also, anyone can own and contribute to one.

And now with the new tax law in effect, you should know about a big change in the rules for taking tax-free withdrawals from a 529. 

Starting this year, parents can take money out tax-free to pay for the tuition-related costs of K-12 education at a public, private or religious school. However, unlike unlimited withdrawals for post-secondary education costs, allowable K-12 expenses are limited to $10,000 per beneficiary per year. Also, it's not yet clear what public K-12 school costs, if any, will qualify as tuition until the IRS gives further guidance.

Previously, 529s provided tax-free funds only for post-secondary education, such as college tuition, fees, room and board, and required computer software or equipment. Tax-free withdrawals are also allowed for post-secondary tuition at a trade or vocational school, or for other qualifying career training programs.

The K-12 change makes 529 plans more versatile for parents and grandparents who are looking to get a head start on paying the future education costs of their children and grandchildren.

It also makes them a better option than the less widely used Coverdell Education Savings Account, or ESA. These accounts let parents save tax-free for expenses related to college, high school, middle and elementary school. But they limit savings at $2,000 per year per child until the beneficiary reaches age 18. 529s have no such contribution limits.

But the IRS does limit tax-free "gifts" to the beneficiary child at $15,000 per year. The rules also let you front-load a child's 529 plan account with five years of gifts by making a $75,000 deposit at once and no new contributions for the next five years. Since the various 529 plans are run by their states' sponsors, the states set overall contribution limits, which typically range from $400,000 to $500,000.   

The new tax rules also allow 529 account owners to transfer assets to ABLE Accounts, as long as they follow the limits for annual deposits to an ABLE Account. These special tax-advantaged accounts allow families to accumulate savings for a disabled child without affecting the child's eligibility for government benefits such as Medicaid and Social Security disability income.

Finally, before you accumulate money in a 529 plan, you should know what happens to the money if your beneficiary receives financial aid, a scholarship or a grant that pays for most of the child's tuition. The financial aid may not cover other costs, so a 529 can pay for books, supplies and room and board.  

And what happens to a 529 if your child doesn't go to college right out of high school? After all, 34 percent of high school graduates didn't enroll in college in 2017. Costs for college or a trade school at a later date are eligible. Since there is no time limit on when 529 assets must be used, you can just let the account grow until whenever your beneficiary decides to pursue higher education.

And if the child you've named as beneficiary of a 529 account doesn't need this money or doesn't ever go to college, you can change the beneficiary to someone else in your immediate family who might benefit. Eligible beneficiaries include siblings, a spouse or children of the beneficiary; cousins, nieces, nephews, aunts, uncles, grandparents or a parent.

Finally, 529 withdrawals for any reason other than qualified education expenses will trigger federal income tax -- and a 10 percent penalty on the untaxed earnings. Given the many allowable uses, this should be the last resort.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.