What Is a 529 Plan?

When it comes to saving for college for your loved ones, you have a few options, including:

• Savings accounts
• Investment plans
• Trust funds

But nothing is more synonymous with college savings than the 529 college savings plan. Yet, many savers may not understand the ins and outs of these plans.

Here's a primer on what 529 plans are, how they work, and what you need to know before deciding if a 529 plan is right for you.

What is a 529 plan?

A 529 plan is a tax-advantaged investment account designed to help Americans save for education expenses. The account owner (typically the parent) sets up the 529 plan on behalf of a beneficiary (typically their child) and controls the money, even after the beneficiary reaches the age of majority.

Like 401(k) retirement accounts, 529s are named after the IRS code that governs its tax deferment, but 529 plans are managed at the state level. That means each state administers its own 529 plan, and your options and details can vary from state to state, even when you open one through a national brokerage such as Charles Schwab.

A 529 plan comes with two general options: prepaid and savings.

Prepaid 529

In a 529 prepaid tuition plan, you can pay current rates now to cover future tuition. For example, a prepaid 529 plan might allow you to pay a year's worth of in-state tuition at the current rate, and the beneficiary will get a year of tuition paid for, regardless of how much tuition increases between now and when they actually go to college.

Prepaid plans are state-specific, so your payments only apply for in-state public schools. Few states still offer them, and those that are left are increasingly shutting down the programs.

As of mid-2023, prepaid tuition plans are available in:

• Florida
• Maryland
• Massachusetts
• Michigan
• Mississippi
• Nevada
• Pennsylvania
• Texas
• Washington

529 Savings

The more common type of 529 plan -- and the one we'll focus on in this guide -- is a 529 savings plan. This is an investment account that works like a retirement savings account.

You contribute money, choose an investment option (often target-date funds, a type of mutual fund that gradually shifts your asset allocation as college or retirement gets closer), and your money is allowed to grow in a tax-advantaged way. The 529 savings plans are available in all U.S. states, and you don't necessarily need to participate in your own state's plan if you like another one better. Also, savings aren't restricted to schools in a plan's state; you can use them anywhere.

Tax benefits of a 529 plan

As investment vehicles, 529 savings plans come with a few potential tax benefits.

• Tax-deferred growth: While your money is in a 529 plan, it can grow and compound without incurring taxes, which could lower your tax bracket and reduce your overall tax bill.
• Tax-free withdrawals: As long as you use the money in your 529 savings plan for qualified education expenses, the beneficiary won't pay taxes on withdrawals, either -- no matter how much the account has gained. For example, if you contributed a total of $10,000 to a 529 plan and the account is worth $25,000 by the time the student is in college, the $15,000 profit is completely tax-free as long as they use it toward education expenses.
• Possible state tax deductions: Unlike retirement plans, 529 plan contributions aren't deductible on your federal income tax return. However, many states let you deduct contributions on your state income tax return.529 contribution limits

529 contribution limits

Contribution limits vary by state, but generally they're high enough to cover undergraduate tuition at any select institution.

For example, as of mid-2023, South Carolina allows a maximum account balance of up to $540,000 per beneficiary. This can be through multiple accounts. Grandparents could contribute to an account with $300,000 and parents could have a separate account with $240,000 for the same beneficiary, and then they'd be maxed out.

Looking around at some other states, Virginia's direct-sold 529 plan has a $550,000 cap per beneficiary. Texas also has a cap of $500,000, and New York's limit is $520,000.

Limits may change over time, so check your chosen state's 529 plan website or ask a financial advisor to keep an eye on your current limit.

What is a 529 plan qualified expense?

Beneficiaries are only able to make tax-free withdrawals from a 529 if they use the funds for "qualified education expenses." Qualified education expenses for the purpose of a 529 college savings plan include the expenses that are required to enroll in and attend an accredited private or public college or university.

These include:

• Tuition
• Required fees
• Required books
• School supplies
• Computers
• Housing (on or off campus)
• A meal plan

The cost of housing is a qualified expense even if the student lives off campus, but it's capped at the amount reported by the college in its annual cost of attendance.

Private K-12 expenses

In addition to college education, you can use a 529 plan to pay for elementary and secondary education expenses. The 529 savings plans were expanded as part of the Tax Cuts and Jobs Act of 2017 to cover tuition expenses of up to $10,000 per year for K-12 schools.

What is not a qualified education expense?

Funds from a 529 plan don't cover things like health insurance premiums (even if they are paid to your school) or transportation expenses to, from, or around campus.

College application fees and testing fees are also not qualified expenses, even if you're required to pay them to attend the school.

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

Beneficiaries are allowed to withdraw money from a 529 savings plan at any time for any reason. If they use the money for anything other than qualified education expenses, they'll owe a 10% federal tax penalty plus federal income taxes on the plan's earnings.

Here's how that works: Say you've contributed $10,000 to your child's 529 plan, and the account is worth $25,000 when they're ready to attend college. If your child doesn't go to college and you withdraw the $25,000 for another purpose, you'll pay the 10% penalty on the plan's earnings ($15,000), but not on your original $10,000 contribution. You'll also need to claim the $15,000 as part of your taxable income for the year of the withdrawal.

The same applies for any partial withdrawals not used for qualified expenses. The withdrawal will be allocated proportionally among tax-free contributions and taxable earnings, and you'll pay the penalty and taxes on the taxable portion.

In the example above, say you only withdraw $5,000. You'll pay the penalty and taxes on an amount proportionate to the $15,000 earnings on your $25,000 balance. So $3,000 of the $5,000 is taxable. Of the $20,000 remaining in your account, $12,000 will still count as earnings.

What to do with extra 529 plan funds

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

Designate a new beneficiary

You can change the designated beneficiary of a 529 plan to another family member whenever you want by rolling funds into a new account for the new beneficiary. Under the IRS definition, a “family member” must be the beneficiary's:

• Spouse
• Child
• Stepchild
• Sibling
• In-law
• Parent
• First cousin
• Parent's sibling
• Sibling's child

This is usually a quick and easy process. For example, if your oldest child ends up having leftover 529 funds, you could roll them into a 529 account for a younger sibling.

Similarly, you could hold on to the funds and roll them into an account for the beneficiary's child. You're not required to use them within any timeframe, so funds can roll over from generation to generation.

Save the funds for more education

The beneficiary could use the funds for education costs at any point. So you can keep the money in the account until you want to pull it out for undergrad education or graduate school down the line, no matter how many years pass.

Roll it over into a Roth IRA

Beginning in 2024, you'll be able to roll over up to $35,000 of unused 529 plan money into a Roth IRA in the beneficiary's name per the new SECURE Act 2.0 rules. To roll over unused 529 plan funds, the account must be at least 15 years old. Beneficiaries will be allowed to roll over an amount equal to the Roth IRA contribution limits each year until they've depleted the 529 account or hit the $35,000 maximum.

Withdraw the money for non-qualified expenses

If you don't have an education-related need for the funds, you can always withdraw them and pay the penalty. Just make sure you account for the penalty and taxes when considering how you'll spend the money. You might not want to withdraw everything at once if it would mean a significant boost in taxes one year.

How to choose a 529 plan

Your home state's plan is a good place to start your search for the right 529 plan. If you live in a state that has an income tax, there's a good chance 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 a plan with the most appealing fee structure and investment options.

Similarly, be aware that several states have more than one 529 savings plan, and fees can vary a lot among them. 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, as is the case in several other states.

How to open a 529 plan

How you open a 529 plan varies depending on the state operating the plan and the private company managing it.

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.)

Many states also offer advisor-sold 529 plans, which can be helpful if you're unsure about how to invest the money you contribute. Your state's 529 website likely lists financial advisors who are licensed to sell these plans, and you can open one by contacting the advisor.

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

The bottom line is that there 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 the extra expense is worth it.

Other college savings accounts to consider

A 529 plan is not the only way you can save for college. Here are some alternatives.

Coverdell ESA

The other major education-specific investment account is a Coverdell Education Savings Account, 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 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.

Roth IRA

You could also save for college by opening a Roth IRA.

Although Roth IRAs  are designed for retirement, you can avoid the 10% early withdrawal penalty on withdrawals for qualifying higher education expenses. If you're younger than 59 1/2, you'll still pay income tax on the earnings portion of the distribution, though. 

If the beneficiary doesn't end up going to college, you can simply use the money toward your own retirement. This is a great option for anyone who wants to save a college nest egg but isn't sure whether the beneficiary will need it.

Savings accounts

Though your earnings will be minimal, a savings account is a good way to save additional money for college. You won't get any special tax breaks, but you won't have to worry about market fluctuations.

The bottom line on 529 plans

As college tuition gets more expensive, it makes sense to start saving early to help your loved ones pay for education. While a 529 savings plan can be a great way to save for college, it isn't the only way. Weigh the pros and cons of all your options before deciding.