How 529 college savings plans work

You’ve got your own financial house in order—you’re earning a solid paycheck, you’ve got an emergency fund in a high-yield savings account, and you’re contributing to a retirement account such as a 401(k). Now, your thoughts are turning to saving for college, perhaps for children or grandchildren already in the picture or for those you hope will be part of your life later on.

One useful financial vehicle for this situation is a 529 college savings plan, which allows you to begin saving money as early as you like to make future withdrawals tax-free when it’s time to pay for your child, grandchild or other beneficiary’s education expenses.  

Before opening such a savings plan, it’s key to understand what exactly 529 plans are, how they work and how they impact your overall college costs. Read on and we’ll break it all down.

What is a 529 plan? 

A 529 plan is a tax-advantaged savings investment vehicle, also known as a qualified tuition plan, that’s designed to help you pay for a designated beneficiary’s future education costs. Contributions to a 529 plan are made using after-tax dollars, so withdrawals are not subject to federal income tax when paying for qualified education expenses later on. Depending on your state’s tax laws, your qualified withdrawal may also be state income tax-free. 

One common myth is that only parents of the beneficiary can open a 529 account, but that’s not true. Anyone age 18 or older with a Social Security number or tax ID number is eligible to open a 529 plan account for the benefit of themself or someone else—which includes grandparents, aunts and uncles, godparents, and even non-relatives of the beneficiary.

Who offers 529 plans?

You can find 529 plans sponsored by states and by private educational organizations. Currently, every state in the U.S. except Wyoming offers a 529 plan. You are not required to invest in a 529 sponsored by the state where you live, although some states may offer additional incentives to do so. You are also not required to use the funds from a 529 for a school in the same state as where your 529 investment is. The money in a 529 plan can be used for any eligible education institute, and is not state-specific. 

Types of 529 plans 

There are two types of 529 plans available depending on which state you live in: prepaid tuition plans and education savings plans. 

Prepaid tuition plans 

A prepaid 529 plan lets you lock in today’s tuition rates for future enrollment at participating colleges. Plan funds can be applied to up to five years of tuition, which can be a two- or four-year program, or a combination of these two programs. But, most prepaid tuition plans do not cover expenses like room and board or supplies.

It’s important to note that not all states offer prepaid tuition plans and those that do may have specific restrictions on how you can use those funds, such as only receiving the full tuition amount for an in-state school. Be sure to carefully review your state’s plan prior to opening to determine if it meets your individual needs.  

Pays for: Future college tuition at participating colleges and universities. 

If your student chooses to attend a private or out-of-state school, your plan may provide a proportional amount to pay for their tuition. Most prepaid plans allow you to transfer the plan to the beneficiary’s sibling if they are under a specific age. 

Requirements: Many state-sponsored prepaid plans require the account holder or the beneficiary to be a resident of their state at the time they apply for a plan. Some plans also implement an age limit for the beneficiary. 

Education savings plans

Education savings plans let you open an investment account dedicated to saving for a beneficiary’s future college costs beyond tuition. 

Pays for:

• Participating college, graduate, or apprenticeship program tuition and fees
• Participating elementary and secondary school (K-12) tuition and fees
• Student loan repayments
• Room and board
• Books and supplies
• Computers and Internet access for course work while enrolled
• Special needs and accessibility equipment

Requirements: Most education savings plans do not require the account holder or beneficiary to be a resident of their state. 

Prepaid tuition plan	Education savings plan
Pays for tuition only	Pays for tuition and other expenses
May have residency requirements	Usually does not have residency requirements
May have age limits	Usually does not have age limits
Offered by select states	Offered by most states

Pays for tuition only
Education savings plan	Pays for tuition and other expenses
May have residency requirements
Education savings plan	Usually does not have residency requirements
May have age limits
Education savings plan	Usually does not have age limits
Offered by select states
Education savings plan	Offered by most states

529 plan fees and expenses

Any fees and expenses charged by an investment plan lower the overall return on your investment. Depending on the plan type and who offers it, the amount you pay may vary. Here are the general types of fees you may be subject to when opening a 529 plan:

Prepaid tuition plans: 

• Enrollment fee
• Application fee
• Ongoing administrative fees

Education savings plans:

• Enrollment fee
• Application fee
• Annual account maintenance fees
• Ongoing program management fees
• Ongoing asset management fees
• Sales load fees (charged by a broker)
• Ongoing distribution fees (charged by a broker)

How to avoid excess fees: Purchasing a plan through a broker may increase the amount of fees you pay to maintain the account. Consider looking into plans sold directly by your state, as a possible option to avoid additional brokerage fees. 

Some plans may also waive fees if you meet specific requirements—such as maintaining a high account balance, enrolling in an automatic contribution plan, or residing in the same state that offers the plan—so thoroughly review the plan’s fee structure for potential savings. 

How 529s are taxed

Qualified tuition plans are a tax-advantaged way to save for future expenses because your earnings grow tax-free while invested in the account. This means the longer your money is invested, the greater your tax benefit will be—so it’s beneficial to begin saving as early as possible. 

Contributions: Your state may offer tax benefits for contributing to a 529 plan, such as state income tax deductions or grants. Eligibility for these benefits may change depending on whether your plan is sponsored by a state or institution. Before opening an account, consider consulting a tax advisor about possible state specific tax benefits.

Withdrawals: In general, withdrawals from 529 accounts used for qualified expenses are not considered taxable income at the federal and sometimes state level. 

However, withdrawals for non-qualified expenses are considered taxable income at the federal and sometimes state level and incur an additional 10% federal tax penalty on any earnings in the account. 

There are some instances where you will not have to pay a 10% penalty to withdraw funds, such as:

• Beneficiary dies or becomes disabled
• Beneficiary receives a tax-free scholarship
• Beneficiary receives employer-sponsored tuition assistance 
• Beneficiary attends a U.S. military academy

Contribution and withdrawal limits

529 plans have limitations on the contributions and withdrawals from the account. 

Contributions: State-sponsored 529 plans limit the amount of contributions per beneficiary to avoid excess funds in the account following completion of the education program. Plan limits can generally range from $235,000 to $575,000, but may change depending on your individual state tax laws. 

Withdrawals: There is no specific dollar limit on how much you can withdraw tax-free each year from a 529 plan if you are using the funds on qualified college expenses. 

But, if you plan to use the funds to pay back student loans, there is a $10,000 lifetime limit per beneficiary. This means that any funds leftover can be transferred to the beneficiary’s sibling to pay back their student loans, up to their individual lifetime limit. 

If you plan to use the funds to pay for K-12 education, there is a $10,000 annual limit. Beyond this amount is considered taxable income in the year it is withdrawn. 

Can you transfer a 529 plan?

You can transfer a 529 plan to a qualifying family member of the beneficiary without tax consequences. This can be done at any time by filling out a form on your plan’s website. 

Qualified family members of the beneficiary include:

• Spouse
• Child, stepchild, foster child, adopted child, son-in-law, daughter-in-law, or descendent
• Sibling, step sibling, brother-in-law, or sister-in-law
• Parent, stepparent, father-in-law, or mother-in-law 
• Aunt, uncle, or their spouse
• Niece, nephew, or their spouse
• First cousin, or their spouse

It’s important to note that there can only be one beneficiary of a 529 plan at any given time. So families can use a single plan for multiple children, but can only withdraw funds from the account to pay for one child’s qualifying expenses at a time with incurring penalties. 

Even though using the same plan for multiple children is possible, this is generally discouraged since most 529 plans are invested in age-based portfolios, which take into consideration the time horizon for the funds to grow, says Patricia Roberts, chief operating officer of Gift of College.

Impact on financial aid eligibility

Funds in a 529 plan will impact  how much financial assistance is needed to afford college, up to 5.64%. 

But this may not have a significant impact as  a majority of financial aid packages include student loans. So, higher savings in a 529 may mean your student will incur less student loan debt than if they did not participate in a plan. 

“Having the 529 plan is much more valuable than counting on a form of aid you may or may never get,” says Roberts. “[Financial aid] is often not free money. It’s money that needs to be repaid.”

Pros and cons of 529 plans

Saving for college can be a daunting task. Here’s what to consider when it comes to 529 plans.

The takeaway

A 529 plan offers tax and savings advantages to save for education. College, vocational school and private primary education costs are expensive and a 529 plan offers a reprieve by way of a long-term savings plan that allows you to accumulate funds over time coupled with tax benefits. Most parents who plan on sending their children to college can benefit from starting a 529 plan early and most college-bound young adults can benefit from a plan someone has started for them.