What Is a 529 Plan?

College Savings 529 Plan Explained

College student studying
•••

 Cavan Images/Getty Images

A 529 college savings plan is an investment account that allows you to invest money for education. These investing plans have federal tax savings and various tax benefits depending on the state you live in.

Learn more about these educational funds, and find out some advantages and disadvantages about them.

Definition and Examples of a 529 Plan

A 529 plan is an account with a portfolio of investments you place money into and hope for it to grow over time. These portfolios are usually managed for you so that you can invest in them like a mutual fund.

The 529 plans date back to 1986 and have become widely used investment vehicles for saving for college. What makes these plans so attractive is that while contributions aren’t deductible, their earnings will grow federal tax-free and will not be taxed when the money is taken out for qualified education expenses. In addition to the federal tax break on earnings, 34 states and the District of Columbia currently offer full or partial state tax deductions for contributions to a 529 plan.

  • Alternate name: 529 college savings plan, qualified tuition plan, college savings plan

How Does a 529 Plan Work?

College savings plans are fairly simple on the user end. You identify an institution you'd like to use for college fund investing, such as your bank. Look through their 529 plans, which will be designed to grow aggressively, moderately, or conservatively. Which you choose depends on your child's age, how much money you'd like them to have, and how much risk you want to take on.

You contribute as much as you want or can to the 529 plan up to the amount that is necessary to fund their education. You can keep making contributions for as long as the plan is open. If you have friends or relatives who would like to give your child a gift, you can send them the information to contribute funds into the account directly.

The money placed in the account is invested according to the strategy of the plan's management, and it grows (or shrinks) with the value of the assets held in the account's portfolio.

The money that is placed into a 529 plan grows tax-free. When your child needs to access the account for their education, there are generally no taxes or penalties. If funds are withdrawn for reasons other than education, taxes and penalties are likely to apply.

In most cases, the funds held in a 529 can only be used for educational purposes. Which expenses the funds cover depends on the type of plan they are held in.

Types of 529 Plans

There are two types of 529 plans: the college savings plans and the prepaid tuition plans. Here are some of the most important highlights of each plan.

College Savings Plans

  • This plan allows you to build an education fund within an individual investment account. The money you contribute is invested in one or more specific investment portfolios that consist of a mix of investments chosen and managed by the plan’s designated money manager.
  • Funds can be used to pay for qualified expenses at any college accredited by the U.S. Department of Education, including undergraduate colleges, graduate and professional schools, two-year colleges, and technical and trade schools. Certain foreign colleges and universities are also included.
  • The plan manager may charge you a fee for administering your account and will pass along investment expenses.
  • When applying for financial aid, the plan is generally considered the parents' or grandparents' asset.
  • Qualified expenses are not restricted to tuition and fees—room and board are included, too.
  • Choice of schools does not affect investment return.
  • These plans are not state-guaranteed.

Prepaid Tuition Plans

  • These plans allow you to purchase tuition now for use in the future through either a contract plan or a unit plan.
  • A contract plan promises to cover a predetermined amount of tuition expenses in the future in exchange for a lump sum or periodic contributions.
  • With a unit plan, you purchase a certain percentage of units or credits. The plan guarantees that whatever the percentage of college costs such units cover now, the same percentage will be covered in the future.
  • Prepaid plans typically charge a flat enrollment fee, and there may be some ongoing administrative charges.
  • When applying for financial aid, the plan is generally considered the parents' or grandparents' asset.
  • Specified enrollment (limited).
  • They might be limited to undergraduate school.
  • They are generally restricted to tuition and mandatory fees (not room and board).
  • May restrict out-of-state costs and, if less than in-state costs, will not return the difference.

Pros and Cons of 529 Plans

There's plenty to consider with a 529 plan, and it can be a useful savings tool and a good addition to your financial planning strategy. However, the plan does have a few limitations, and it's worth knowing the pros and cons.

Pros
  • Offers a Private College Plan option

  • No income restrictions

  • Useful for estate planning

  • Qualified withdrawals are not counted as income

  • No income or capital gains taxes

  • Transferrable

Cons
  • Can't be used for private primary schooling

  • Pre-paid tuition plan might not cover all expenses out-of-state

  • Cash only deposits

  • Might affect needs-based financial aid

  • Incur penalties for using the funds for non-qualified distributions

Pros Explained

  • Private plans: The "Private College 529 Plan," an updated version of the Prepaid Tuition plan, lets you buy tuition at a discount ahead of time for schools in a 293-member consortium that includes Stanford, Princeton, and Vanderbilt Universities.
  • No income restrictions: 529 Plans are an investment of choice because there are no restrictions on income. Note that 529 plan limits vary by state/program. The contribution limit for 529 plans cannot exceed the amount needed to pay for qualified education expenses.
  • Estate planning: Since the account can accept larger-than-usual financial gifts, it can help grandparents with estate planning issues.
  • Tax-deferred growth: The money in your 529 accounts grows tax-deferred, and you don't have to pay federal income tax when using the funds for qualified education purposes.
  • Qualified withdrawals are not income: Account withdrawals don't count as income for either the student or the parent, so they don't affect calculations for financial aid.
  • Transferrable: The plan can be transferred to another family member if your child decides to skip college and do their own thing.

Cons Explained

  • Not for primary schooling: A 529 is less flexible than a Coverdell plan because it doesn't cover K-12 expenses.
  • You may need to pay extra: If you use a 529 prepaid tuition option, you'll have to pay any difference in tuition if your child decides to go to an out-of-state or private school. In some cases, if your child doesn't get accepted into a state school, you can use the funds for community college tuition, put them into a regular 529 account or transfer them to a relative, but in that case, the money can only pay tuition and not room, board, or any other college fees.
  • Cash only: You can't transfer investments into the plan; these plans only accept cash.
  • Might affect needs-based financial aid: If you have a 529 plan, you may not qualify for needs-based tuition assistance.
  • Fees for non-qualified use: The funds must be used for qualified distributions, or you'll have to pay taxes on the taxable portion and a possible 10% fee.

Alternatives to 529 Plans

If, after reviewing 529 plans, you've decided that they don't work for you, take comfort in the fact that plenty of other options exist. You can use any of the following vehicles to put money aside for education, although each has its own benefits and limitations:

  • Coverdell Education Savings Account, which can also be used for K-12 expenses
  • A trust to control access to the money
  • A custodial account in the name of the minor child
  • A Roth IRA
  • Cash-value life insurance, if purchased early in the child's life and used as a loan that may or may not be repaid (unpaid loans reduce the death benefit)

What It Means for Families

Normally, one person can only gift a total of $15,000 per year per person without incurring gift taxes. However, you can gift up to five years of the annual $15,000 exemptions at once when contributing to a child’s post-secondary education. This is a great bonus for anyone who wants to gift in a lump sum.

Another bonus associated with 529 plans is that you aren’t restricted to using them in the state in which you reside. You will want to look for a plan that meets your objectives and goals, and you should do your due diligence on the plan itself and the fund managers.

Qualified tuition plans (529s) are sponsored by many states, state agencies, and educational institutions. Shop around to find one that fits your needs and budget the most.

In its most recent survey of college pricing, reports for the 2020-21 academic year showed that the average cost of tuition and fees was $37,650 at private colleges, $10,560 for state residents at public colleges, and $27,020 for out-of-state residents attending public universities.

Those numbers are in today’s dollars, so if you've recently had a baby and you’re looking at college costs that are 18 years away, those prices may increase significantly.

With all of ​life's hefty expenses, it's easy to put off education funding. Most Americans will need to save for a long time to have enough to cover four years of college. Starting early is the best action you can take. If you're unsure where or how to begin, one great place to start is by looking into a 529 plan.

Key Takeaways

  • A 529 plan is a tax-advantaged account that uses investments to grow money for educational purposes.
  • There are two types of 529 plans—the college savings plan and the prepaid tuition plan.
  • There is no limit to how much can be contributed to a 529 plan other that it must only be enough to fund an education.
  • Anyone can contribute to a 529 plan, making it a great option for family and friends who might want to help fund an education.