A 529 plan is an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary. You can use a 529 plan to pay for college, K-12 tuition, apprenticeship programs, and even student loan repayments. If you use a 529 plan to save for college, your savings will have a minimal impact on financial aid eligibility.
Types of 529 Plans
If you’re saving for college, you can choose from many types of plans. The government characterizes 529 plans as prepaid tuition or college savings plans. Here is how each of these types of plans works:
- College savings plans: These are considered tax-advantaged savings plans. They work much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds or similar investments. The 529 college savings plan offers several investment options from which to choose. The 529 plan account will go up or down in value based on the performance of the investment options. You can see how each 529 plan’s investment options are performing by reviewing our quarterly 529 plan performance rankings.
- Prepaid tuition plans: These plans let you pre-pay all or part of the costs of an in-state public college education. You may also convert them for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges sponsored by more than 250 private colleges.
Educational institutions can offer a prepaid tuition plan but not a college savings plan. The first education savings plan was a prepaid tuition plan: the Michigan Education Trust (MET) was created in 1986. More than a decade later, Section 529 was added to the Internal Revenue Code, authorizing tax-free status for qualified tuition programs. Today, over 100 different 529 plans are available to suit various education savings needs.
529 Plan Tax Benefits
A 529 college savings plan works much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds, ETFs, and other similar investments. Your investment grows tax-deferred, and you can withdraw your funds tax-free if you use the money to pay for qualified higher education expenses. Contributions are not deductible from federal income taxes.
Depending on where you live, you may also qualify for a state tax benefit. More than 30 states offer state income tax deductions and state tax credits for 529 plan contributions. These tax benefits make 529 plans better for college savings accounts than traditional savings or investment accounts. Some families use 529 plans as an estate planning vehicle since contributions are considered completed gifts to the beneficiary. Up to $17,000 per donor, per beneficiary, qualifies for the annual gift tax exclusion in 2023.
How to Choose a 529 Plan
Nearly every state has at least one 529 plan available, but you’re not limited to using your home state’s plan. Each 529 plan offers investment portfolios tailored to the account owner’s risk tolerance and time horizon. Your account may go up or down in value based on the performance of the investment option you select. Considering your investment objectives and comparing your options before investing is essential.
Choose a 529 plan based on the investment approach you like the best. However, you can still dictate how you invest your account with many 529 plan providers. The state sponsoring your plan has no benefits or drawbacks as long as it is a nationwide 529 plan.
The two main things you may want to consider when deciding on your plan are any potential fees and the history of returns from the plan. You can read our article on the best 529 plans if you want our opinion and ratings on those two main elements of choosing the right plan.
How Much Can I Contribute to a 529 Plan?
There are no annual 529 plan contribution limits. However, some essential things to consider when making a significant contribution. For example, contributions in excess of the annual gift tax exclusion ($17,000 in 2023) will count against your lifetime estate and gift tax exemption ($12.92 million in 2023).
Each state also has an aggregate contribution limit for 529 plans, which ranges from $235,000 to $550,000. The price of attending an expensive college and graduate school program, including textbooks and room and board, determines this amount. As a general rule of thumb, aiming to save about one-third of your projected future college costs is a good goal. This assumes you can cover the remaining two-thirds with current income, including scholarship funds and student loans.
What happens if I can’t afford monthly contributions?
Most plans allow you to set up automatic recurring deposits from a linked bank account, but it’s not required. After you make a minimum initial contribution requirement (sometimes as low as $25), you can invest as much as you want, whenever you want.
You may make lump sum contributions around birthdays, holidays, or other occasions. 529 plans also accept gift contributions from family, friends, and other loved ones.
Will Having a 529 Plan Affect Financial Aid?
When a dependent student or one of their parents owns a 529 plan account, there is a minimal impact on the student’s financial aid eligibility compared to other savings accounts, such as an UGMA/UTMA account. The Free Application for Federal Student Aid (FAFSA) gives favorable treatment to assets held in the 529 plan, and reports don’t include distributions. Beginning with the 2024-2025 FAFSA, even distributions from 529 plans owned by third parties, like grandparents or other family members, will not negatively impact financial aid eligibility.
What Are Qualified Education Expenses?
It’s important to understand that with a 529 plan, only qualified withdrawals are tax-free. You should only use your 529 plan to pay for qualified educational expenses. 529 plan withdrawals must happen in the same tax year as the expenses incurred. This means that if you’re paying for January expenses, you can’t withdraw funds in December of the previous year, even though it’s only weeks from when you need the money.
Qualified expenses for college include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access, and special needs equipment for students attending a college, university, or other eligible post-secondary educational institutions.
However, there are some education costs that you may believe are necessary, but the IRS does not consider a qualified expense. For example, a college must charge a student’s health insurance and transportation costs as part of a comprehensive tuition fee for them to be qualified expenses. Alternatively, the college must identify the fee as “required for enrollment or attendance.”
In recent years, the IRS has expanded the definition of qualified education expenses beyond traditional college costs, including K-12 tuition expenses and student loan repayments. There is a $10,000 annual limit on qualified K-12 withdrawals and a $10,000 lifetime limit on student loans. Another option is to use the savings plan for registered apprenticeship program expenses.
The funds in a 529 plan are yours, and you can always withdraw them for any purpose. However, the earnings portion of a non-qualified distribution will be subject to ordinary income taxes and a 10% tax penalty, though there are exceptions.
Can I Use a 529 Plan to Pay for Rent?
Yes, room and board is considered a qualified expense if the student is enrolled at least half-time, which most colleges and universities consider to be at least six credit hours per term.
For on-campus residents, qualified room-and-board expenses can be, at most, the amount charged by the college for room and board. For students living off-campus, regulations qualified room and board expenses to its cost of attendance figures. Contact your financial aid office for more information.
How to Withdraw Funds From a 529 Plan
You can use your education savings to pay for college costs at any eligible institution, including over 6,000 U.S. colleges and universities and more than 400 international schools. For example, you can be a California resident, invest in a Virginia plan, and send your student to college in North Carolina.
Once you’re ready to start taking withdrawals from a 529 plan, most plans allow you to distribute the payments directly to the account holder, the beneficiary, or the school. Some plans may allow you to pay directly from your 529 accounts to another third party, such as a landlord. Remember, you must check with your own plan to learn more about how to take distributions from your account. Depending on your circumstances, you may need to report contributions to or withdrawals from your 529 plan on your annual tax returns.
What Happens if My Child Doesn’t Go to College?
The future is always uncertain, and some parents worry about losing the funds they saved in a 529 plan if their child doesn’t go to college or gets a scholarship. Generally, you will pay income tax and a penalty on the earnings portion of a non-qualified withdrawal, but there are some exceptions. The penalty is waived if:
- The account beneficiary receives a tax-free scholarship
- The account beneficiary attends a U.S. Military Academy
- The account beneficiary dies or becomes disabled
However, the earnings portion of the withdrawal will be subject to federal income tax and sometimes state income tax. The biggest misconception about a 529 plan is that you can never use your funds again, which is false. Also, the taxes and penalties will only be on the portion you earn in the 529 accounts, not the contributions.
What Happens to Money Not Used in a 529 Plan?
If you have leftover money in your 529 plan and you want to avoid paying taxes and a penalty on your earnings, you have a few options, including:
- Change the beneficiary to another qualifying family member
- Hold the funds in the account in case the beneficiary wants to attend grad school later
- Make yourself the beneficiary and further your own education
- Roll over the funds to a 529 ABLE account, a savings account specifically for people living with disabilities
- Since January 1, 2018, parents also have the option to take up to $10,000 in tax-free 529 withdrawals for K-12 tuition
- Since January 1, 2019, qualified distributions from a 529 plan can repay up to $10,000 in student loans per borrower for both the beneficiary and the beneficiary’s siblings
- Beginning in 2024, up to $35,000 of 529 plan assets may be rolled over into a Roth IRA if the plan has been open for at least 15 years.
Remember, you can withdraw leftover funds in a 529 plan for any reason. However, the earnings portion of a non-qualified withdrawal will be subject to taxes and a penalty unless you qualify for one of the exceptions listed above. If you are contemplating a non-qualified distribution, be aware of the rules and possible tactics for reducing taxes owed.
Can You Lose Money in a 529 Savings Plan?
While you will not lose unused funds, it is important to note that most 529 plan investment options entail market risk and investments in equities and bonds. For risk-averse investors, many 529 plans offer FDIC-insured account options or ‘stable value’ portfolios, which offer lower risk but also lower returns.
How to Open a 529 Plan
Opening a college savings plan is easy. You can open a direct-sold 529 plan by completing an application on the plan’s website. Direct-sold plans offer lower fees than advisor-sold plans, but the account owner is responsible for selecting the investments. Advisor-sold 529 plans are only available through licensed financial advisors.
Who Can Open a 529 Plan
One of the advantages of 529 plans is that just about anyone can open one. Parents, grandparents, friends, and even students themselves (if they are 18 years old) can open a 529 college savings plan to start a college fund. You can open an account and name a beneficiary who doesn’t even know about it until you want them to use the funds.
While anyone can open a 529 plan, each plan can only have one beneficiary at a time. You can change beneficiaries down the road if one child doesn’t go to college but another does, but you can’t name multiple children as beneficiaries simultaneously. The beneficiary also does not have to be the owner of the 529 plan and often is not the owner.
Frequently Asked Questions (FAQs) on 529 Plans
What states sponsor 529 plans?
Nearly all states sponsor 529 plans, and a variety of financial partners manage them. Most states offer nationwide plans where anyone can open an account. A handful of plans are only for state residents. Florida, Louisiana, New Jersey, South Carolina, South Dakota, and West Virginia offer these plans.
Can I invest in 529 plans sponsored by states other than my home state?
Yes, you can invest in any nationwide 529 plan. You do not have to be limited to the plan sponsored by the state where you live.
How much does a 529 plan grow?
The growth rate of your assets in a 529 plan will depend on several things to predict the growth. It will depend on how much you have invested, what types of investments you have, how long you’ve had your 529 plan and the overall market growth. You can use our free college savings calculator to help you estimate how your 529 account could grow.
What is a 501b plan?
A 501 retirement plan is similar to other types of retirement plans like an IRA. It was created with the specific purpose of to help union members contribute to their pension funds. You cannot use these funds for anything other than retirement benefits. You cannot use a 501 account to pay for college expenses until you hit retirement and withdraw funds.
Is there an earnings limit to investing in a 529 plan?
There are no income restrictions for 529 plans. Anyone can contribute to an account until it reaches the total contribution limits that the state sponsoring the plan sets. These amounts typically range between $350,000 and $550,000.
Can a 529 plan account be used at schools outside the state that sponsors the plan?
You can use your 529 plan assets at any eligible school, including any financial aid-accredited school. This means that you have plenty of options nationwide and even some schools abroad where you can use your 529 assets. You can now even use funds in your account for K-12 private school tuition.
Who controls the account for 529 plans?
The account is owned by whoever opens the account, not necessarily the beneficiary. It is typically owned by a parent, grandparent, aunt, uncle, or another family member of the beneficiary. The account holder can decide how to invest the account and who the current beneficiary is at any time.