What Is a 529 Plan? Everything You Need to Know
The college admissions and financing process is nothing short of daunting for many Americans. With higher education costs skyrocketing — the average annual cost of college in the United States was $36,436 in 2023 — it’s never been more important to start saving for college as early as possible.
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The 529 college savings plan is one of many financing options you may have heard about or investigated on your own. This tax-advantaged account offers several benefits, including tax-free growth and withdrawals for qualified education costs like college tuition, K-12 tuition and apprenticeship programs. Read on to explore the basics of 529 plans and how they work.
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What Is a 529 Plan and How Does It Work?
A 529 plan is a college savings plan that provides tax advantages when used for qualifying purposes. A 529 plan is something like a Roth IRA or 401(k) plan designed for educational savings. Contributions are not federally tax-deductible, but earnings grow tax-free, and distributions for qualifying educational expenses are also tax-free [4]. Many states provide a tax deduction or tax credit for residents using an in-state 529 plan.
A 529 plan has an owner and a beneficiary, but they can be the same person. The owner chooses the beneficiary, selects the investments and determines when withdrawals will be made. The owner can also change the beneficiary at any time, without the beneficiary’s approval. This can open up various strategic options for a 529 plan that you might want to discuss further with your tax or financial advisor.
Types of 529 Plans
When selecting a 529 plan, you can choose between an education savings plan and a prepaid tuition plan. The best option depends on several factors, including your financial needs and preferences. Here’s how they compare:
Education Savings Plans: These function similarly to Roth IRAs, allowing contributions with after-tax dollars. The earnings within the account grow tax-free without accruing capital gains, and qualified withdrawals are exempt from federal taxes, and most states allow an exemption from state income taxes . Almost all states and the District of Columbia offer these plans.
Prepaid Tuition Plans: These plans let you lock in future tuition costs at in-state public colleges, potentially offering significant savings. However, they typically have limited flexibility and may not be transferable to private or out-of-state institutions. A handful of states still have prepaid tuition plans available for new enrollees, and you’ll find a few hundred private colleges across the country with their own prepaid tuition plans.
529 Plan vs. Roth IRA
Although 529 plans and Roth IRAs are tax-advantaged accounts that you fund with after-tax dollars, they serve two different purposes for different stages in life. You can withdraw money from a Roth IRA to pay for education expenses, but it can come with a high price tag. First, the money has to stay in the account for at least five years, and you have to meet one of the following criteria to withdraw money as a qualified distribution:
Be at least 59 1/2 years old
Use the money to pay first-time homebuyer expenses
Have a qualifying disability
Your beneficiaries can also withdraw money from your Roth IRA after your death without paying a penalty. The IRS will waive the early withdrawal penalty if you’re younger than 59 1/2 and use the money to pay for college expenses. But you will likely pay income tax on the withdrawal — not FICA or capital gains tax.
Using 529 Plans
While nearly every state offers its own 529 plans, selecting the right one requires more than finding an option available in your state. With a variety of plans available, it’s crucial to consider factors like investment choices, associated fees, state tax benefits and your personal tolerance for risk.
1. Choose a Plan
Your first task is choosing between a 529 prepaid tuition plan and a 529 education savings plan. A prepaid tuition plan lets you pay today’s tuition rate for tomorrow’s education, a significant advantage when you consider how the cost of tuition has increased, on average, 9% each year since 2002. These plans typically have residency requirements, and you may not get to use all of the money you’ve saved if the beneficiary decides to attend an out-of-state school or one that’s not on the plan’s approved list.
If you prefer a plan with more flexibility, an education savings plan may be the better choice. In many cases, you can use the funds to pay for tuition, room and board and other expenses at any school, including K-12 private schools. The trade-off is that your money is exposed to market risk and the risk of not stretching as far as you expected if the cost of tuition rises significantly between the day you open the account and your child goes to college. You also may pay a management fee to the group investing your money.
2. Open an Account
529 plans are accessible to almost anyone, regardless of income level and relationship to the beneficiary. This means aunts, uncles and friends of the family can open one for your child. You can open an account online or through a financial advisor and designate a beneficiary who doesn’t even need to be aware of the plan initially. Check with the agency overseeing 529 plans in your state or reach out to a broker to open the account.
If you open a 529 education savings plan, you may be asked to choose an investment option, typically from a selection of mutual funds, exchange-traded funds and bank products. Some plans operate with portfolios targeted for specific dates that mature when the beneficiary graduates from high school.
2. Contribute
You — along with family members and friends — can contribute to the 529 plan each year by depositing money in the account. Annual contribution limits vary, ranging from $235,000 in Georgia and Mississippi to $575,000 in Arizona. The IRS does consider these contributions gifts, so any amount over the annual exclusion limit–$18,000 in 2024–is subject to federal tax.
During the contribution stage — from the day you open the account until you start making withdrawals — you can make deposits into the account as often as you like within the annual limits. This can be done through regular payments throughout the year or in lump sums when you receive a bonus or tax refund. Some brokerages have set up online systems that you can share with others who want to contribute in lieu of a gift for birthdays and other celebrations. If you opt for a prepaid tuition plan, you may have to make installment payments.
3. Withdraw Funds
You can use funds from your 529 plan to pay for qualified education expenses at eligible institutions nationwide. Withdrawals for qualified expenses are tax-free, but non-qualified withdrawals are subject to income tax and a 10% penalty.
What Are Qualified Education Expenses?
Qualified education expenses include more than tuition and fees for a college. You also may be able to use the funds in an education savings plan to pay for the following as long as the plan beneficiary uses them and they are required for enrollment in a specific program:
Apprenticeship programs
Books
Computers
Interest or principal payments on education loans
Room and board
Software
Supplies and equipment, including adaptive learning tools for students with special needs
Tuition at a qualifying K-12 school
States oversee the 529 education plans, so check the guidelines for the state where you live for the most current list of qualified education expenses. For example, in 2018, the IRS expanded the law in 2018 to allow 529 owners to use up to $10,000 per year to pay for tuition at K-12 schools.
Pros and Cons of 529 Plans
The main attraction of a 529 plan is its tax advantages. However, like any investment or savings vehicles, 529 plans come with benefits and disadvantages that make them better tools for some savers than others. Understanding these pros and cons can help you decide if it’s right for you.
What Are the Benefits of 529 Plans?
Anyone can contribute to a 529 regardless of tax bracket.
Early withdrawal penalty encourages saving.
Earnings grow tax-free.
May be able to get a state tax deduction for your contributions.
Money is considered a parental asset, an advantage for financial aid.
Unused funds can be rolled over to a Roth IRA or given to a new beneficiary.
Withdrawals for qualifying educational purposes are tax-free.
What Are the Downsides of a 529?
Funds in the 529 are considered an asset in financial aid calculations.
Owner makes all decisions about the account and controls the funds.
Plans have fees, including management and maintenance fees and mutual fund expenses..
Plan details vary, depending on the state’s rules.
Withdrawals for non-qualifying education expenses come with fees and penalties.
Other College Savings Options
Custodial accounts, also known as UGMA/UTMA accounts, generally offer more investment flexibility and can be used for any purpose at all, not just qualifying educational expenses. While not having the tax benefits of a 529 plan, their flexibility might appeal to families who are unsure whether or not they’ll be able to spend the money on qualifying educational expenses.
A Roth IRA is another way to set aside savings that can be used for any purpose and can be invested in a wide range of assets. Although Roth IRA earnings can’t be withdrawn without penalty before age 59 1/2, contributions can be withdrawn tax- and penalty-free at any time, for any purpose . In that sense, a Roth IRA can act as a type of hybrid account; contributions can be withdrawn for educational expenses if needed, but if not, assets can remain in the account and grow until retirement.
Is a 529 Plan Worth It?
The advantages of a 529 plan make it a smart way to save for college in certain circumstances. For example, if you’re sure you’ve got a child who’s destined for higher education and you can afford to make contributions, the 529 plan is an excellent way to go. However, if you have to sacrifice your retirement savings to make 529 contributions, or if you’re not sure you’ll have the opportunity to take the money out for college expenses, it might not be the slam dunk that it appears to be.
John Csiszar contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: What Is a 529 Plan? Everything You Need to Know
