A 529 plan is a tax-advantaged savings account that helps you save for your loved one's education expenses. Whether you're a parent, guardian, or grandparent, a 529 plan offers benefits like tax-free growth and withdrawals for qualified education costs. This makes it a powerful tool to invest in your child's or grandchild's education, giving you a flexible and effective way to plan for their future.
This article covers the basics of 529 plans, often called 529 college savings plans, their pros and cons, and tips for choosing the best option for your needs.
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What is a 529 plan?
A 529 plan is a tax-advantaged savings account designed to help families save for future education expenses. Named after Section 529 of the Internal Revenue Code, these plans come in two forms: college savings plans and prepaid tuition plans. Contributions are invested in options like mutual funds, and earnings grow tax-free if used for qualified expenses.
529 plans aren’t just for college. “They can also be used for K-12 tuition, apprenticeship programs, and even certain international schools,” says Adam Garcia, certified financial planner and founder of The Stock Dork. Each state offers its own version of a 529 plan, often with unique tax benefits. Although specifics vary, all 529 plans help families save for education with tax-free growth and withdrawals when used for qualified expenses.
How does a 529 plan work?
You can open a 529 plan to save for someone's education. The beneficiary can be of any age—whether a child, adult, or even older individual—with the funds growing tax-free as long as they are used for qualified educational expenses.
Understanding 529 plan rules helps you maximize its benefits and avoid penalties. Below are the key rules and considerations:
Qualified education expenses
Funds must be used for eligible expenses to maintain tax-free status. These include tuition, fees, books, supplies, equipment, and room and board for students enrolled at least half-time. 529 plans can also cover K-12 tuition up to $10,000 per year and student loan repayments up to a lifetime limit of $10,000 per beneficiary.
Contribution limits
States set maximum aggregate 529 plan contribution limits, typically between $200,000 and $500,000 or more. This is the total amount that can be contributed and accumulated in the account for a single beneficiary over time, including growth. Additionally, there is an annual contribution limit based on the annual gift tax exclusion, which is $18,000 per beneficiary in 2024. This means that contributors can add up to $18,000 per year without incurring gift taxes or needing to file a gift tax return.
Penalties for non-qualified withdrawals
If you/your child use funds for non-qualified expenses, you’ll have to pay income tax and a 10% penalty on earnings. There are exceptions: if the child receives a scholarship, attends a U.S. military academy, or passes away.
Pros and cons of 529 plans
While 529 plans offer significant benefits for education savings, they also come with certain limitations. Below is a summary of the main pros and cons to help you evaluate whether a 529 plan fits your financial goals.
Pros
- Tax advantages: Contributions grow tax-free, and withdrawals are also tax-free for qualified education-related expenses.
- High contribution limits: States set aggregate limits between $200,000 and $500,000, allowing for significant savings.
- Flexibility: Funds can be used for a variety of educational expenses, including K-12 tuition, college costs, and student loan repayments (with limits).
- Potential state tax benefits: Some states provide tax deductions or credits for residents contributing to a 529 plan.
- Ownership and control: The account owner retains control over the funds, even after the beneficiary reaches legal age.
Cons
- Penalties for non-qualified withdrawals: If the funds are not used for qualified education expenses, earnings are subject to income tax and a 10% penalty.
- Investment risk: Since the funds are typically invested in mutual funds or similar options, there is always a risk of losing value depending on market performance.
- Limited to education: “Using it for any other purpose incurs penalties and limits investment options,” Garcia says. This restriction makes 529 plans less flexible than other savings vehicles.
How to choose the best 529 plan
Choosing the right 529 plan depends on factors like your state, available investment options, and tax benefits. “Look for low-fee options, and pay attention to the benefits offered by state-sponsored plans,” Garcia says. “Interestingly, some states allow non-residents to participate in their plans.”
Here are some key factors to consider:
- State vs. out-of-state plans: Research if your state offers a tax deduction or credit for contributions. Even if it doesn’t, you can invest in out-of-state plans, which may offer better investment options or lower fees. Compare plans to find the best fit for your financial goals.
- Tax considerations: If your state does offer tax deductions for 529 contributions, check if there are income limits. Knowing these details helps you maximize potential tax benefits.
- Fees and investment options: Evaluate each plan’s fees, investment options, and overall performance. Finding a balance between low fees and strong investment choices is key. Consider using a 529 plan calculator to estimate how much you need to contribute to reaching your education savings goals effectively.
How to open a 529 plan
Opening a 529 plan is a straightforward process. Follow these steps to get started:
- Choose a plan. Research different state-sponsored 529 plans and select the one that meets your needs. Consider factors like state tax benefits, fees, and investment options.
- Open an account. You can typically open a 529 plan account online through the plan's official website or with a financial advisor. Some plans may offer guidance to help you understand how the plan works and how to maximize its benefits.
- Name a beneficiary. Designate a beneficiary—typically, the future student for whom you're saving. The beneficiary can be changed later if needed.
- Select investments. Choose from the investment options offered by the plan, such as age-based portfolios that adjust as the beneficiary nears college age or more customized options that align with your risk tolerance and financial goals.
- Contribute. Start contributing to the account, either as a lump sum or through regular contributions. Some plans allow for automated contributions, making it easier to stay consistent. Contributions can also be made by family members or friends, which is especially helpful for gift-giving occasions.
- Monitor and adjust. Regularly review investments and contributions. Adjust as needed to ensure savings align with future education costs.
Maximize the benefits of your 529 plan
To get the most out of your 529 plan, set up automatic contributions to grow savings steadily. Take advantage of state tax deductions if available, and regularly review investments, adjusting them as your child nears college age. If you have leftover funds, you can change the beneficiary to another eligible family member without penalty.
Additional uses and new opportunities for your 529 plan savings
Beyond traditional education expenses, 529 plans can also cover apprenticeship programs and up to $10,000 in student loan repayments per beneficiary. It’s now also possible to roll over funds from a 529 plan into a Roth IRA for the beneficiary.
“Recent legislative changes enable a limited transfer of 529 account funds into Roth IRAs if the account has been open for at least fifteen years,” says Yosef Adde, a financial advisor, investor, and real estate agent. “This allows beneficiaries more leeway in managing post-graduation projects.” And it means your money won’t go to waste.
Common misunderstandings about 529 plans
When it comes to 529 plans, some misunderstandings often lead to confusion. Here are common misconceptions and the realities behind them:
- Transfer of funds: Many believe that if the original beneficiary doesn’t use the funds, the money is lost or penalized. In reality, the funds can be transferred to another eligible family member without penalty, providing flexibility for changing needs.
- Limited to traditional colleges: 529 plans aren't restricted to traditional universities—they also cover trade schools, apprenticeship programs, and other post-secondary institutions.
- Impact on financial aid: Some think a 529 plan drastically reduces financial aid eligibility. While 529 plans are considered in aid calculations, their impact is generally smaller compared to assets owned by the student, such as savings accounts, custodial accounts (like UTMA or UGMA), or investment accounts.
- Non-qualified withdrawals: Not all education-related expenses are covered. Costs like travel, application fees, and health insurance are not qualified expenses under IRS guidelines, meaning withdrawals for these are subject to income tax and a 10% penalty on earnings.
Bottom line
A 529 plan is a powerful tool for saving for education, thanks to its tax advantages and flexibility. Understanding the rules, pros, and cons helps you choose the best plan for your needs. Whether for college, K-12 tuition, or apprenticeships, a 529 plan provides an effective, tax-beneficial way to save for education. Recent updates add even more flexibility to how you can use these savings.