How do 529 plans work?

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Mark Kantrowitz

By Mark Kantrowitz

August 2, 2018

A 529 college savings plan is a specialized savings account that is used to save money for college. Each 529 plan account has an account owner, who controls the investments and selects the beneficiary, and one beneficiary. The account owner and beneficiary may be the same person. The money in a 529 plan may be used to pay for the college expenses and K-12 tuition of the beneficiary, tax-free.

Many families find that 529 plans work well, helping them achieve their college savings goals. 529 plans make it easier to save, with the option to schedule automatic investments as low as $15 or $25 a month transferred from a bank account or payroll check. 

Tax and financial aid benefits

Named after section 529 of the IRS tax code, which was added in 1996, 529 college savings plans provide families with several tax and financial aid advantages.

Contributions to a 529 plan are made from after-tax dollars. Earnings accumulate in a 529 plan on a tax-deferred basis. Qualified distributions from a 529 plan are entirely tax-free.

In 35 states (including Washington, DC), contributions to the state’s 529 plan are eligible for a state income tax deduction or tax credit.

Annual contributions to a 529 plan in excess of the $15,000 annual gift tax exclusion ($30,000 for a couple giving together) are eligible for 5-year gift tax averaging, which treats the contributions as occurring proportionately over a 5-year period. This allows an individual to make a lump sum contribution to a 529 plan of up to $75,000 ($150,000 for a couple) without incurring gift taxes. 

If a 529 plan is owned by a dependent student or the dependent student’s parent, the 529 plan is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA) and distributions are ignored. This yields a more favorable financial aid treatment than student assets. Student assets reduce eligibility for need-based aid by 20% of the asset value, compared with at most 5.64% of the asset value for parent assets. 529 plans that are owned by anybody else are not reported as assets on the FAFSA, but distributions count as untaxed income to the beneficiary, reducing eligibility for need-based aid by as much as half of the distribution amount.

Wondering how your 529 plan may impact financial aid? Use our Financial Aid Calculator to estimate the expected family contribution (EFC) and your financial need.

Other benefits of 529 plans

In addition to the tax and financial aid advantages, 529 plans offer several other key benefits.

You can start a 529 plan at any time. There is no limit on the number of 529 plans you can set up.

The account owner controls the account, not the child. The child does not gain control over the account upon reaching the age of majority. The account owner can change the beneficiary if the child does not go to college. 

Anyone can contribute to a 529 plan. There are no income phase-outs on contributions to a 529 plan. There is no age limit on contributions. 529 plans have high aggregate contribution limits, which range from $235,000 to $520,000, depending on the state.

There is no age limit for using the money in a 529 plan. There are no income phase-outs on distributions from a 529 plan. 529 plans can be used to pay for graduate school, medical school and law school, not just undergraduate school.

Some states and some cities provide a small contribution to the 529 plan of each newborn child if the 529 plan account is opened before the child’s first birthday. This seed money has been shown to increase the likelihood that the child will enroll in and graduate from college. Other states will match contributions of low-income families to their children’s 529 plans.

How to choose a 529 plan

Since you can invest in any state’s 529 plan, not just your own state’s 529 plan, you have many choices available.

  • Consider your own state’s plan, especially if you live in one of the 35 states (including DC) that provide state income tax deductions or tax credits for contributions to the state’s 529 plan.
  • Look at 529 plans that offer the lowest fees. Minimizing costs is the key to maximizing the net return on investment.
  • Compare 529 plans based on net performance, after subtracting the fees.

You can enroll in a 529 plan directly, or through a financial advisor. Although advisor-sold plans come with higher fees, a financial professional with college savings expertise will be able to help with choosing a plan and selecting investment options. 

How to select a 529 plan investment option

When you enroll in a 529 plan you will be able to select the investment options that best suit your needs. Most 529 plans offer a few dozen investment options to choose from. The investment options include static funds, such as a U.S. stock fund, international stock fund, real estate fund, bond funds, money market accounts and cash. Some also offer bank CDs. You can mix these funds to achieve any particular asset allocation, according to your risk tolerance or risk preference.

Most 529 plans also offer dynamic investment options, such as age-based asset allocations. An age-based asset allocation shifts the mix of investments from aggressive to conservative as college age approaches. These are like the target date funds used in retirement plans.

How to make contributions to a 529 plan

Minimum contribution requirements vary by 529 plan, but some are as low as $10, $15 or even zero. Initial contributions can generally be made by check or electronic deposit, and subsequent contributions can also be made by automatic deposits or payroll deduction. Some plans offer lower contribution requirements for account owners who sign up for an automatic investment plan linked to a checking or savings account. 

Scheduling regular monthly 529 plan contributions is an easy way to stay on top of your savings goal, but it’s not required. Some parents prefer to deposit an initial lump sum, and then fund subsequent contributions with money from holiday or birthday gifts. It’s up to you to contribute as much as you want, whenever you want. 

Grandparents and other loved ones can also make contributions to a child’s 529 plan. Many plans now offer customizable web pages, social media announcements and email templates that can be sent to friends and family to make a secure electronic contribution. Gifts can also be made via cash or check to the account owner, or with Gift of College gift cards. 

How much to save

The amount each parent needs to save will vary based on the age of their child and what type of school they will attend. The table below illustrates current college costs and the recommended amounts to save each month for a future student. 

Type of school 
2017-18 annual cost
Projected total cost 
of college in 17 years*
Required monthly 
Public 4-year college (in-state)
Public 4-year college (out-of-state)
Private non-profit 4-year college 

*Source: College Board Trends in College Pricing report. Assumes current inflation rates of 3.1%, 3.2% and 3.5%. 

Qualified and non-qualified expenses

529 plans have a broad definition of qualified higher education expenses, which include:

  • Tuition and fees at thousands of accredited U.S. colleges and universities and hundreds of foreign colleges and universities that are eligible for Title IV federal student aid
  • Books, supplies and equipment
  • Special needs services
  • Room and board, if the student is enrolled at least half-time
  • Computer and peripheral equipment, software and Internet access (but not an Xbox, PlayStation or other gaming systems)
  • Student Loans

Since 2018, K-12 school tuition is also considered a qualified expense for 529 plans, up to $10,000 per beneficiary per year.

All other expenses are non-qualified. The earnings portion of a non-qualified distribution is subject to ordinary income taxes at the beneficiary’s rate, plus a 10% tax penalty. The tax penalty will be waived if the beneficiary receives a scholarship, veterans’ educational assistance, employer-paid tuition assistance or other forms of tax-free educational assistance, attends a U.S. military academy, or claims the American Opportunity Tax Credit or Lifetime Learning Tax Credit, but only to the extent of the assistance, credit or benefit received.

What happens if the beneficiary doesn’t go to college?

If the designated beneficiary decides not to go to college, you can always change the beneficiary to another qualifying family member, save the funds for a future grandchild or use the money to further your own education. Or, you can take a non-qualified withdrawal at any time for any reason. Only the earnings portion of the distribution will incur taxes and penalty. Your contributions (the principal) will never be taxed or penalized since they were made with after-tax dollars. 

What is a prepaid tuition plan?

Technically, prepaid tuition plans are also 529 plans, but everybody calls them prepaid tuition plans. Hardly anybody calls them prepaid 529 plans any more. A prepaid tuition plan locks in tuition at current rates by letting you buy tuition units or years of tuition. A year’s tuition will always be worth a year’s tuition.

But, you will usually have to pay a premium on current tuition rates, to make up the shortfall between investment returns and increases in college costs. Many prepaid tuition plans are suffering from actuarial shortfalls and do not have enough money to cover all future tuition obligations. Some prepaid tuition plans offer guarantees, but their guarantees may not be backed by the full faith and credit of the state. Even if the prepaid tuition plan is guaranteed by the state, it isn’t clear what the guarantee really means. Many prepaid tuition plans have closed to new investment and will not cover full tuition costs. The money might not be there when your child is ready to use it.

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