How Do 529 Plans Work?

November 3, 2023

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.

Each 529 account is designated for one beneficiary only. 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 saving easier, 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 breaks.

Annual contributions to a 529 plan above 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 five years. This allows an individual to make a lump sum contribution to a 529 plan of up to $75,000 ($150,000 for a married couple) without incurring gift taxes as long as there are no other contributions over the next five years.

Suppose a dependent student or the dependent student’s parent owns a 529 plan. In that case, parents must report the 529 plan as an asset on the Free Application for Federal Student Aid (FAFSA), and distributions are not reported. This results in a more favorable financial aid treatment than student assets.

Student assets reduce aid eligibility for need-based aid by 20% of the asset value, compared with at most 5.64% of the asset value for parent assets. However, if a 529 plan is owned by someone else other than the dependent student or their parent, such as a grandparent, it is not reported as an asset on the FAFSA. And with new changes to the FAFSA, distributions from a grandparent 529 plan are no longer reported either. 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 attend college. The beneficiary may also use the investment account for apprenticeship programs.

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, law school, and even secondary 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. These programs are not universally available and often have specific eligibility requirements. Nevertheless, 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 brokerage. 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 types of 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 mutual funds and bank CDs. You can mix these funds to achieve any particular asset allocation according to your risk tolerance or risk preference.

Most 529 plans 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. These plans offer excellent tax benefits for those looking to save for higher education.

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. You can open these accounts with your home state providers or any other provider you prefer.

Scheduling regular monthly 529 plan contributions is an easy way to stay on top of your education 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 education costs and the recommended amounts to save each month for a future student.

Type of school	2023-24 annual cost	Projected total cost of college in 17 years*	Required monthly contribution
Public 4-year college (in-state)	$24,030	$103,258	$263
Public 4-year college (out-of-state)	$41,920	$215,772	$550
Private non-profit 4-year college	$56,190	$268,358	$684

*Source: College Board Trends in College Pricing report. Assumes current inflation rates of 2.5%, 3.0% and 4.0%.

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 fees are also considered qualified education expenses 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-advantaged 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.

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-advantaged 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?

Suppose the designated beneficiary decides not to go to college. In that case, 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 penalties. 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 anymore. 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 suffer from actuarial shortfalls and need more money to cover all future tuition obligations. Some prepaid tuition plans offer guarantees, but the full faith and credit of the state may not back their guarantees. Even if the state guarantees the prepaid tuition plan, it isn’t clear what the guarantee 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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