Published in: Buying Stocks | Oct. 25, 2019

What Is a 529 Plan?

We are committed to full transparency as part of our mission to make the world smarter, happier, & richer. You should know that offers on The Ascent may be from our partners - it's how we make money. That transparency to you is core to our editorial integrity, which isn’t influenced by compensation.

Here's everything you need to know about these popular college savings accounts.

When it comes to saving for college for your children or other loved ones, there are many ways you can do it. You can invest in stocks, bonds, or mutual funds through a brokerage account. You could simply put money in CDs or a savings account. Or you could use your own retirement savings to help foot the bill.

There are also some ways to save that are specifically designed for college savings, and none are more popular than the 529 plan. However, these accounts aren't well understood by many Americans, so here's a primer on what 529 plans are, how they work, and what you need to know to decide if a 529 plan is right for you. 

A parent holding hands with their young child wearing a backpack.

Image source: Getty Images

What is a 529 plan?

A 529 plan is a special type of investment account designed to help Americans save for educational expenses. These plans are operated by individual states -- in other words, Florida has its own 529 plan, as do most other states. Some states have more than one 529 plan to choose from.

Technically speaking, there are two main types of 529 plans: prepaid and savings. In a 529 prepaid tuition plan, you can pay current rates ahead of time for future study. For example, a prepaid plan might allow you to pay a year's worth of in-state tuition at the current rate, and your child will get a year of tuition paid for, regardless of how much tuition increases between now and when they actually go to university.

However, prepaid 529 plans aren't widely available. Only a few states have prepaid plans that are open to new participants.

The more common type of 529 plan is a 529 savings plan. This works in a similar fashion to most employer-sponsored retirement plans -- you contribute money, choose an investment option (or several), and your money is allowed to grow in a tax-advantaged way. 529 savings plans are offered by all U.S. states, and you don't necessarily need to participate in your own state's plan if you like another one better.

We'll get to the details in a bit, but for the remainder of this discussion, you can safely assume we're referring to 529 savings plans unless otherwise specified.

Tax benefits of a 529 plan

There are a few potential tax benefits that come with 529 savings plans, so let's take them one at a time.

First, there's the tax-deferred investment growth. In a standard investment account, you'll get a tax statement at the end of the year for all of the interest, dividends, and capital gains your account generated. And these are generally considered to be taxable income. In a 529 savings plan, however, you won't have to worry about paying taxes on these types of investment returns on an annual basis. While it's in the account, your money can grow and compound, and the tax is deferred.

Second, as long as you use the money in your 529 savings plan for qualified educational expenses (more on that later), your withdrawals will be 100% tax-free no matter how much your account has grown. In other words, if you contributed a total of $10,000 to a 529 plan and the account is worth $25,000 by the time your child is in college, the $15,000 profit is completely tax-free, providing you use it toward qualifying expenses.

These first two items are similar in nature to the tax structure of a Roth IRA. However, there's a third potential benefit that could make a 529 even more appealing.

Since 529 savings plans are run by the individual states, many states offer state tax deductions for contributions as well. Obviously, this doesn't apply if you live in a state with no state income tax, and it's important to emphasize that 529 contributions are never deductible on your federal tax return, but this can still be a big benefit.

529 contribution limits

Because 529 plans are operated by the states, contribution limits can vary. In general, however, 529 savings plans have extremely high contribution limits. And they may change over time, so it's a good idea to check your 529 plan's website or ask your advisor to find out your limit.

Just as an example, South Carolina's 529 savings plan stops accepting contributions once a beneficiary has $500,000 in the plan. And this doesn't necessarily have to be in the same account -- for example, if grandparents contribute to an account with $300,000 and parents have an account with $200,000 for the same beneficiary, it would trigger the cutoff.

Looking around at some of the other states, I see that Virginia's direct-sold 529 plan has the same $500,000 cap for new contributions. Texas has a lower cap where it cuts off new contributions at a $370,000 balance, and New York's limit is slightly higher at $520,000 per beneficiary, to name a few.

The point is that while the exact limits differ, a maxed-out 529 savings plan is typically enough to cover four or five years of all-in costs of attendance at pretty much any college or university in the United States. In other words, it's rare for a 529's contribution limit to not be enough.

Qualified educational expenses

We've referred to the phrase "qualified educational expenses" several times elsewhere in this discussion, so let's define exactly what that means. And it's changed a bit in recent years.

In a nutshell, qualifying expenses for the purpose of 529 plans include the expenses that are required to enroll in or attend an accredited college or university. This includes tuition and any required fees, books that are required, school supplies, computers, housing (on or off-campus), and a meal plan. If the student lives off campus, the cost of housing that can be paid through a 529 plan is capped at the amount reported by the college in its annual cost of attendance.

It does not include things like health insurance premiums (even if they are paid to your school), or any transportation expenses to, from, or around campus. Likewise, college application fees are not qualified expenses, and the same goes for any testing fees you may have to pay. 529 funds cannot be used to cover these expenses, even though they might be necessary expenses of attending school.

In addition, a 529 plan can be used to pay for K–12 expenses. Well, sort of. This is the part that changed recently. As part of the Tax Cuts and Jobs Act, the use of 529 savings plan funds was expanded to include tuition to K–12 schools, with a maximum withdrawal of $10,000 per year for this purpose. So if your child might go to a private school before college, it's important to know that you can use a 529 plan for those costs..

What happens when withdrawals aren't used for qualifying education expenses?

It's important to mention that you can withdraw money from a 529 savings plan at any time and for any reason. However, if you withdraw money from a 529 plan that you own, and the money is not used for qualifying expenses, the IRS will assess a 10% penalty.

This penalty is only assessed on the portion of the withdrawal that represents the plan's earnings, not on your original contributions. Let's say that you've contributed $10,000 to your child's 529 plan and that the account is worth $25,000 when they reach college age. If your child doesn't go to college and you withdraw the $25,000, you'll pay the 10% penalty only on the $15,000 of the account that represents the earnings.

In addition to the penalty, the earnings portion of any non-qualified 529 plan distributions is also considered to be taxable income. Continuing the previous example, that $15,000 in 529 earnings would also be subject to any applicable federal, state, and local taxes.

In the case of partial non-qualified withdrawals (not the full account balance), the withdrawal will be allocated proportionally when it comes to contributions and earnings. In other words, you can't simply take $1,000 out and avoid penalties and taxes by saying that you're just withdrawing your original contributions.

What if the beneficiary doesn't use all of the money in the account?

If you end up saving more money in a 529 than the beneficiary needs to cover their educational expenses, there are a few options.

First and foremost, you have the option to change the beneficiary of a 529 plan to another family member whenever you want. Or more specifically, you can roll the funds over into an account for the new beneficiary. Under the IRS definition, this means the beneficiary's spouse, child, stepchild, siblings, in-laws (parents or siblings), parent, aunt, uncle, niece, nephew, or first cousin. This is usually a quick and easy process. For example, if my oldest child ends up having leftover 529 funds, my plan is to roll them into a 529 account for her younger brother. 

Other alternatives include using the account to help cover graduate school costs, or to simply withdraw the money yourself and eat the penalty (although that's rarely the most financially prudent option).

How to choose a 529 plan

Your home state's plan is a good place to start your search, especially if you live in a state that has an income tax, as there's a good chance that you'll get a state tax break for your contributions. If your state doesn't have an income tax, it could make more sense to shop around for the plan with the most appealing fee structure and investment options.

On a similar note, be aware that several states have more than one 529 savings plan, and they can be rather different in terms of the fees you'll pay. For example, South Carolina has two -- a 529 savings plan sold directly through the state, and another that is sold by financial advisors. The advisor-sold option is by far the more expensive.

How to open a 529 plan

The process to open a 529 plan varies, since they are operated by the states and are managed and distributed by third-party companies. Many states have direct-sold 529 college savings plans, which you can enroll in directly by filling out a short application and providing some personal information about you and the beneficiary. (Tip: Have the beneficiary's Social Security number handy before applying.)

In many cases, there are also advisor-sold versions of states' 529 savings plans, which can be excellent choices if you're unsure about how you want to invest the money you contribute. These can be opened by contacting a financial advisor licensed to operate in the plan's state.

Generally speaking, the direct-sold version of a 529 plan will have lower fees. Advisor-sold plans generally have higher investment fees, and the advisors who sell them may also get a sales commission upfront that eats 1%–5% of your contributions. The downside to a direct-sold plan is that you're on your own when it comes to investment strategies.

The bottom line is that there certainly is value in speaking to a financial advisor who can help guide your college savings strategy. The question is how much of a premium you'll have to pay for this advice, and whether it's worth the extra expense.

Other college savings accounts to consider

In the interest of being thorough, you should know that a 529 plan is not the only way you can save for college.

The other major education-specific investment account is a Coverdell Education Savings Account, which is better known as a Coverdell ESA. These have the same federal tax treatment as 529 plans. However, unlike a 529 plan, these accounts aren't state-run and can be opened with many major brokerage firms.

There are some advantages to using a Coverdell, particularly when it comes to investment flexibility. With a 529 plan, you're generally limited to a couple of dozen investment funds at best. With a Coverdell, you can invest in virtually any stocks, bonds, or mutual funds you want.

However, in most cases the downsides to using a Coverdell outweigh the advantages. Most significantly, contributions are limited to just $2,000 per year per beneficiary. And there's no possibility of a state tax deduction for contributing.

In addition to a Coverdell, another advantageous way to save for college is through an Individual Retirement Account (IRA), particularly a Roth IRA. A Roth IRA has the same basic tax treatment as 529 plans and Coverdell ESAs, and although they are designed for retirement, there's an exception to the early withdrawal penalty for qualifying higher education expenses. And if your child doesn't end up going to college, you can simply use the money towards your own retirement, making this a great option for parents who aren't sure if their kids will end up using the money.

As student loan debt continues to rise, it makes sense to start saving early to help your loved ones pay for their education. And the bottom line is that while a 529 savings plan can be a great way to save for college, it isn't the only way, so be sure to weigh the pros and cons of all the options before deciding.

Using the wrong broker could cost you serious money

Over the long term, there's been no better way to grow your wealth than investing in the stock market. But using the wrong broker could make a big dent in your investing returns. Our experts have ranked and reviewed the top online stock brokers - simply click here to see the results and learn how to take advantage of the free trades and cash bonuses that our top-rated brokers are offering.