What Is a 529 Plan?May 27, 2022
Last Updated on February 15, 2023
If you are a parent, you likely are worried about future college costs. According to Vanguard, the cost of four years in college will range between $235,358 and $536,171, depending on the type of school your child chooses by the year 2040.
While you can tuck money away into a savings account, most families are unable to save enough to cover the cost of college. Instead, they need the help of stock market returns to allow their money to grow faster.
That’s where 529 plans come in. They’re one of the most popular types of college savings accounts, and with good reason. Originally designed solely for post-secondary education, 529 plans can be used to save for K-12 education and apprenticeship programs, too.
Types of 529 Plans
What is a 529 plan? They are investment accounts with special tax benefits that can be used to cover qualified education expenses. 529 plans are sponsored by states, state agencies, or educational institutions and managed by investment companies. 529 plans come in two forms: prepaid tuition plans and college savings plans.
A 529 college savings plan is an investment account that can be used to cover qualified education expenses at any eligible college or university. Unlike prepaid tuition plans, contributions to 529 college savings plans are made to investment firms that handle the available investment options.
529 college savings plans offer more flexibility than 529 prepaid tuition plans because the money can be used at any eligible college or university. In addition, 529 college savings plan funds can be used for a wider range of expenses, such as room and board, books and supplies, and computers.
529 college savings plans also have some disadvantages. For example, the money in a 529 college savings plan is subject to stock market fluctuations, so there is the potential for loss.
Prepaid Tuition Plans
When considering which college fund for your child is best, you may be thinking about opening a prepaid tuition plan.
With a 529 prepaid tuition plan, you purchase credits or units at participating colleges and universities for future tuition and mandatory fees at those schools. A state or educational institution sponsors the 529 prepaid tuition plan.
The advantages of 529 prepaid tuition plans lock in today’s prices for future tuition and mandatory fees. The 529 prepaid tuition plan credits or units can be used at any participating college or university.
However, there are some disadvantages to 529 prepaid tuition plans. For example, if your child decides not to go to college, you may not get all of your money back. In addition, 529 prepaid tuition plans typically only cover tuition and mandatory fees, so you will need to save separately for other expenses such as room and board.
What Are Qualified Education Expenses?
Withdrawals from a 529 are tax-free and penalty-free as long as they are used for qualified education expenses. Eligible education expenses for college students include:
- School-required fees
- Book, supplies, and equipment
- Room and board if enrolled at least half-time
- Computer and software
If your child is younger, 529 plans can also be used for K-12 education expenses at public, private, and religious schools. With a 529 savings plan, you can withdraw up to $10,000 per year per child for K-12 tuition expenses.
Finally, suppose your child wants to pursue an apprenticeship rather than college. In that case, you can use the 529 to cover fees, books, and supplies for an apprenticeship program that is registered and certified with the Secretary of Labor under section 1 of the National Apprenticeship Act.
If you use withdrawals for other purposes, you could incur a 10% penalty, and you’ll owe income taxes on the amount withdrawn.
Pros & Cons of 529 Plans
Before opening an account, make sure you understand the benefits and drawbacks of 529 plans:
- Withdrawals are tax-free when used for eligible expenses: Money saved in a 529 college savings plan can grow tax-free. And when you use withdrawals to pay for eligible expenses, the money you take out is not taxable.
- You get more from your money: Whether you opt for a prepaid tuition plan or college savings plan, your money will work harder for you in a 529 than it will in a savings account. You can lock in today’s tuition rates or invest in growing your money, allowing you to get a higher return than the low APYs on savings accounts.
- You can switch beneficiaries: With a 529 plan, you can change beneficiaries if the original beneficiary decides against going to college. You can change the beneficiary to another child or even a relative without penalty.
- They have high contribution limits: Unlike Coverdell education savings accounts, another popular tool for college savings, 529 plans don’t have annual restrictions on how much you can contribute. The maximum you can contribute is the total cost of attendance; depending on the state, the aggregate maximum can be as high as $500,000.
- Penalties apply if the money is used for other purposes: If you dip into a 529 to pay for other expenses — for example, to repair a roof or buy a car — you’ll have to pay a 10% penalty, and your withdrawals will be subject to income taxes.
- Not all states offer tax benefits: There are no federal tax deductions for Contributions to 529 plans, and not all states offer tax benefits either.
- You may have limited investment options: Your investment options are dependent on the state you choose to open the 529. Depending on the state, your investment options may be more limited than if you opened a taxable brokerage account on your own.
How to Choose a 529 Plan
A common misconception is that you can only choose a 529 plan offered by your state. However, you can open a 529 run by any state — even one across the country. When comparing your options, consider the following factors:
- Decide between a prepaid tuition plan and a college savings plan: Prepaid tuition plans can be useful if you live in a state that offers income tax deductions or credits for contributions or if you’re concerned about market changes. Otherwise, a college savings plan will likely give you the best return and flexibility.
- Costs and fees: Typically, 529 plans charge asset management fees, which are a percentage of your account. However, make sure you compare the fees to the fund’s returns; a higher fee can make sense if the fund delivers a higher average rate of return.
- Investment options: With a 529 plan, you usually can invest in a pre-selected group of investments. These investments tend to be mutual funds or target-date funds based on when your child will enroll in college.
- Tax benefits: Some states offer tax benefits for residents. For example, taxpayers in Colorado can deduct up to $20,000 in 529 contributions ($30,000 if filing a joint tax return). You can view what tax benefits are available through Invesco.
- Account minimum: Some states have higher account minimums than others. For example, the minimum for some accounts in Nevada is $3,000, whereas Tennessee allows you to open an account with as little as $25.
How to Open a 529 Plan
Once you’ve selected a 529 plan, you can move forward with opening an account. Complete the 529 plan application offered on the state’s website to get started. Or, you may be able to open a 529 plan through your investment adviser or a financial brokerage like Fidelity or Vanguard.
The application will prompt you to enter your information and details about the account beneficiary. You’ll need to provide the beneficiary’s name, Social Security number, and mailing address.
You need to fund your account. Most 529 plans allow you to do that electronically by entering your bank account information.
Once your account is funded — and you opt for a college savings plan — you can choose what investments to make.
Tax Benefits for 529 Plans
A 529 plan offers several tax benefits:
- Tax-Deferred: Your contributions to a 529 plan can grow tax-free as long as it’s in the account.
- Tax-Free Withdrawals: As long as the money you withdraw is used for the beneficiary’s eligible education expenses, the withdrawals are exempt from income taxes.
- State Credits or Deductions: Depending on where you live, you may be eligible for state tax credits or deductions by making 529 contributions.
Just keep in mind that any withdrawals used for non-eligible purchases will be subject to a 10% penalty. In addition, the amount you take out for non-qualifying purchases will incur federal and state income taxes.
529 Plan FAQs
1. How do 529 plans affect financial aid?
Assets in a 529 plan can have a small impact on your eligibility for financial aid. 529 accounts owned by a parent or student are counted at a 5.64% rate when determining eligibility. Qualified distributions from parent or student-owned accounts don’t count as income.
For 529 accounts owned by others, such as grandparents, distributions are counted at a much higher rate because it’s considered untaxed income.
2. Who can contribute to a 529 plan?
Anyone can contribute to a 529 plan, including a parent, aunt, uncle, grandparent, or even a family friend.
3. Can you lose money in a 529 plan?
If you opt for a 529 college savings plan and invest your contributions, there is a risk of losing money if the market performs poorly. One option many people use is to invest in target-date funds. Target-date funds automatically adjust the portfolio to become more conservative as your child’s enrollment date nears, reducing the risk of losing money.
4. What happens to unused money in a 529 plan?
If you have unused dollars in a 529 plan, you can designate a different beneficiary. Or, you can withdraw money from the account. Just keep in mind that withdrawals for non-eligible expenses will incur penalties and income taxes.
5. What can you spend 529 account funds on?
529 funds can be used to cover college tuition, fees, room and board, and supplies. You can also use the money to pay for K—12 education and apprenticeship programs.
6. Is there an age limit on 529 plans?
529 plans don’t have age limits, and you can hold onto them indefinitely.
7. What can I use instead of a 529 plan?
Other options include Coverdell Savings Accounts, high-yield savings accounts, Roth IRAs, or even private student loans. If you’re not sure which is best for you, meet with a financial advisor to discuss your goals.
8. Can you use a 529 to pay student loan debt?
Up to $10,000 can be used in a 529 for student loan debt. An additional $10,000 can be withdrawn to pay off the student loans of the beneficiary’s siblings.
9. What Happens if My Child Doesn’t Go to College?
If your child doesn’t go to college or receives a full scholarship, you can designate another person as the account beneficiary. Or, you can withdraw the money if you’re willing to accept the penalties and pay income taxes on the amount.
10. How much can I contribute to a 529 plan?
A 529 plan doesn’t have annual contribution limits. You can contribute up to the total cost of attendance, but state aggregate limits generally range from $250,000 to $500,000.