What Is A 529 Plan?

If you’re looking to save money for your child’s education, consider a 529 plan. A 529 plan allows you to make tax-free withdrawals to pay for qualified education expenses, such as college tuition and fees.

What Is a 529 Plan?

A 529 plan, also known as a qualified tuition plan, is a tax-advantaged savings plan designed to help you pay for education. While 529 plans were originally earmarked for college and university, they can now be used to pay for K-12 education and apprenticeship programs.

The money in a 529 plan grows tax-deferred and you won’t have to pay taxes on withdrawals if they’re used for qualified education expenses. Parents or grandparents typically hold a 529 account and the beneficiary receives funds once they have school expenses to pay. There’s virtually no limit to the amount you can withdraw for college, but K-12 withdrawals are limited to $10,000 annually.

Although 529 plans are tax-exempt federally, they’re commonly sponsored by most states—Wyoming is the only state without a plan. Most states and Washington, D.C. offer at least one 529 plan, but you’re not strictly limited to the state where you reside. While a handful of states require you to be a resident to use their 529 plans, most do not. However, you may receive extra benefits in your home state’s plan.

There are no income requirements to open a 529 plan, nor are there any annual contribution limits. However, you may be subject to a federal gift tax if you contribute above a certain amount ($17,000 per individual or $34,000 per household in 2023). States also set their own aggregate limits, which range from $235,000 to $550,000.

Types of 529 Plans

There are two main types of 529 plans: savings plans and prepaid tuition plans.

Savings Plans

529 savings plans let you put after-tax dollars in investments, such as mutual funds or exchange traded funds (ETFs) for college or other educational expenses, and the money grows tax-free. You can choose how to invest your funds but your options may be more limited than they would be in a brokerage account. These funds are typically sponsored by states but managed by financial firms.

Some 529 savings plans offer target-date funds, which automatically adjust your assets over the years. They may choose higher-risk investments early on in your savings journey and switch to more conservative holdings as the student approaches college.

When you’re ready to withdraw the savings, you can spend it on tuition, fees and other qualified expenses. If you don’t spend the money on education costs, it will be subject to income tax and a 10% penalty.

Any leftover funds in a 529 savings plan can be switched to another beneficiary, such as a sibling or the account holder themselves. You can also use up to $10,000 from 529 savings on student loan repayment for the account’s primary beneficiary and their siblings.

Prepaid Tuition Plans

Some states and colleges offer prepaid tuition plans, which allow you to lock in today’s rates at participating colleges and universities. When the student attends college in the future, you can pay current prices, even if tuition has increased over the years.

As with 529 savings plans, your funds in a prepaid tuition plan can grow over time. You also won’t have to pay taxes on qualified withdrawals. However, you can’t use prepaid tuition plans to pay for K-12 education or room and board at college.

Plus, your options for spending the money are limited to participating colleges, whereas the funds in a 529 savings plan can be spent at any eligible school.

Pros and Cons of 529 Plans

While there are benefits to opening a 529 plan to save for college or other education, these plans also have potential disadvantages. Consider both the pros and cons when deciding the right move for your family.

Pros

• Tax advantages. Your savings can grow tax-deferred and you won’t have to pay taxes on withdrawals as long as they’re used for qualified education expenses.
• Different types of plans. You can choose between a savings plan or a prepaid tuition plan, depending on your needs.
• Access to out-of-state plans. You’re not limited to your own state’s plan but can shop around. However, your state might offer the best incentives.
• Can switch beneficiaries. If you have leftover funds or your original beneficiary chooses not to go to college, you can switch beneficiaries to another student in the family or the account holder, if they choose to go back to school.
• K-12 education and apprenticeship programs may qualify. While 529 savings plans used to be limited to college costs, they can now be used for these other school expenses, as well as student loan repayment.

Cons

• Investment options may be limited. You can typically choose among preselected investment options, usually mutual funds or ETFs, in a 529 plan.
• Taxes on non-qualifying expenses. While 529 plans offer tax advantages for school costs, you’ll have to pay taxes on withdrawals if you want to use the money for other purposes.
• Annual or administrative fees. A 529 plan’s expense ratios typically average 0.50%, according to Vanguard.
• Could reduce financial aid eligibility. Parent- or student-owned 529 plans must be reported on the Free Application for Federal Student Aid (FAFSA). The impact of parent-owned 529 plans on a student’s financial aid is minimal. However, a student-held account can have a greater impact.
• Federal gift tax may limit contributions. Your contributions are considered gifts to the beneficiary and may trigger a federal tax if they exceed a certain amount. You do have the option to “superfund” a 529 account with a contribution of up to $80,000 (or $160,000 per household) in one year, but this will use up your federal gift tax allowance for five years.

How To Choose a 529 Plan

With 529 plans offered by states and schools across the country, choosing the right one for you and your family can be a difficult decision. There are a few factors to consider when picking a plan, including investment performance, fees and tax breaks.

It’s worth exploring your home state’s offerings first since some states offer state tax deductions for 529 plan contributions. You could also look into your investment options and historical return on investment. If you prefer certain types of investments, such as socially conscious funds, consider a plan that aligns with your values.

Take fees into account when comparing 529 plan options. High annual or administrative fees could add significantly to your costs and reduce your investment earnings. Direct-sold 529 plans tend to charge lower fees than advisor-sold plans.

The College Savings Plans Network offers a helpful online tool that you can use to compare 529 plans, including their tax benefits for state residents, fees, contribution guidelines and other details. You can also compare options with our list of the best 529 plans of 2022.