A 529 plan is a state-sponsored plan that helps parents (and other relatives and friends) save and invest money to pay for a child's college or K-12 education. All states, except Wyoming, and Washington, D.C., offer 529 plans. If you live in an eligible state, here are three reasons to take advantage of a 529 plan.

Father and son relaxing on couch putting coins into pink piggy bank.

Image source: Getty Images

1. 529 plans have tax advantages

One of, if not the main reason, to consider a 529 plan is the tax advantages that come with it. You contribute after-tax money to a 529 plan, and your earnings grow tax-free on the federal level. Withdrawals are also tax-free on the federal level as long as you use the money for qualified educational expenses -- such as tuition, room and board, books, and other fees. Your contributions to a 529 plan are not federally tax-deductible, but you may have additional tax benefits depending on your state.

Since 529 plans are state-sponsored, each state has its own rules regarding deductions and potential tax credits. Generally, you must contribute to your state's 529 plan to be eligible for a deduction or tax credit, but seven states offer tax advantages regardless of where you make contributions:

  • Arizona
  • Arkansas
  • Kansas
  • Minnesota
  • Missouri
  • Montana
  • Pennsylvania

The following states don't offer state income tax credits or deductions for 529 plan contributions:

  • Alaska
  • California
  • Delaware
  • Florida
  • Hawaii
  • Kentucky
  • Maine
  • Nevada
  • New Hampshire
  • New Jersey
  • North Carolina
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming

It's a good idea to consider whether or not your state provides tax benefits so you can make the most out of your 529 plan and its advantages.

2. You have two plan types to choose from

There are two 529 plan options: education savings plans and prepaid tuition plans. With the college savings plan, you contribute money to the investment account, and it's put into a premade portfolio. For example, if you choose an age-based portfolio, the investment allocations adjust with the child's age; the older they get, the more conservative the portfolio gets. Static portfolios keep the same allocation through the account's life unless you decide to adjust it -- which can be done twice per year.

Prepaid tuition plans generally let you buy credits at participating universities, usually in-state and public, for future tuition and mandatory fee costs at their current costs. Unfortunately, room and board and K-12 tuition costs aren't eligible to be paid with this plan type. While the federal government doesn't guarantee prepaid tuition plans, some states will guarantee the money you contribute to the plan.

If your state doesn't guarantee the money contributed to a 529 plan, you risk losing money if the plan's sponsor goes bankrupt or can't cover its financial obligations. If, for whatever reason, the 529 plan beneficiary decides not to attend the participating university, the 529 plan may pay out less money than it would with participating universities.

3. There is a better chance to keep up with rising tuition costs

As with most things, the cost of tuition has steadily increased through the years. CollegeBoard's Trends in College Pricing and Student Aid 2021 study shows that from the 2020-21 school year to the 2021-22 school year, college tuition has increased by the following (before adjusting for inflation):

  • Public two-year: 1.3%
  • Public four-year in-state: 1.6%
  • Public four-year out-of-state: 1.5%
  • Private four-year: 2.1%

With rising tuition costs, you face the problem of money you're saving for a child's education being worth much less relative to tuition by the time they need to access it -- especially if you save it in a regular savings account. According to the Federal Deposit Insurance Company (FDIC), the national average interest rate on savings accounts is 0.06%, much less than the historical rise in tuition costs.

While nothing is guaranteed, money invested in a 529 plan will likely outpace interest earned in a typical savings account. Not only does this help protect money intended for tuition from rising inflation, but it also gives you a chance of higher earnings on your contributions.

A priceless gift

Education can be a major part of any child's life, and graduating from a college or university changes the life trajectory of many people. As a parent, guardian, relative, or even family friend, one of the most valuable things you can contribute to or provide for a child is the chance for a debt-free education. While this may not always be a possibility, a 529 plan offers incentives to help push you toward this goal.