With the cost of a college degree rising steadily, many parents feel a sense of responsibility or even urgency to save for their child's education. One popular way for parents to save for their child’s college education is a 529 plan, which is a tax-advantaged way to save for future qualified college expenses.

Here are some of the rules and benefits that make 529 plans worth considering as you start saving for college. Before deciding on a 529 plan, we encourage you to consult a financial advisor or tax professional to determine what type of 529 plan is right for you.

Benefits of a 529 Plan

Saving for college with a 529 plan provides a variety of federal and state tax benefits. The earnings generated in the account are generally not subject to income taxes each year, allowing the investments to grow tax-free. And when the funds are used for qualified education expenses, the distributions are also not subject to federal income taxes. State tax rules vary.

Many states offer some form of state income tax deduction or credit for contributions made to a 529 plan. Often, the state's tax benefits are dependent on funding an in-state plan.

Qualified Expenses

To be eligible for tax-free withdrawals, the funds must be used for qualified expenses at a college, university, vocational school or other eligible post-secondary institution. Those expenses may include:

  • Tuition and fees
  • Books, supplies and equipment
  • Room and board
  • Computer or peripheral equipment, computer software or Internet access

Types of 529 Plans

There are two versions of the 529 plan to choose from, depending on how you would like to save for college:

  • The 529 Savings plan allows families to set aside funds for future college costs. It works much like an IRA, allowing the owner to invest their contributions in mutual funds or similar investment vehicles. The account goes up or down in value based on the performance of the chosen investments. Most plans have a minimum contribution to start, which can be as low as $25 or $50. Then you can choose to contribute small amounts each month or make lump sum payments on your own schedule.
  • The 529 Prepaid plan allows you to prepay the average tuition at today's prices and use the credits later at qualifying in-state schools. If your child chooses to attend an out-of-state college, you will not get the benefit of guaranteed tuition. Instead, most plans will pay out an amount equal to the tuition and fees at your state's public institution and the student or parent will be responsible for paying the difference.

Matt Hylland, founder and financial planner at Hylland Capital Management in North Liberty, Iowa, says some families prefer 529 savings plans because they are able to save in small increments, unlike prepaid plans which typically require larger monthly installments.

"Savings plans also have the opportunity to generate higher returns so you will ultimately need to save less to pay for college," he says, compared to prepaid plans. "However, there is more risk in 529 savings plans if they are not invested wisely. If your account is heavily allocated to stocks and the stock market drops, you will likely lose some of your savings."

Contribution Limits

The Internal Revenue Service (IRS) does not specify a dollar amount for annual contribution limits to 529 plans. However, because 529 plan contributions are considered gifts for tax purposes, large contributions to a 529 plan can trigger a requirement to file a gift tax return. Check with the IRS or a tax accountant for the gift tax rules that apply to your filing status.

What if Your Child Doesn't Need 529 Plan Funds?

Generally, when money is withdrawn from a 529 plan and is used for anything other than qualified expenses, the earnings portion of the withdrawal is subject to income taxes and a 10 percent penalty.

However, if your child isn't using the money because they received a scholarship, there may be an exemption to the 10 percent penalty if you withdraw an amount adjusted for the scholarship. Even if you don’t pay a penalty, you will have to pay income taxes on the earnings if you do not use the money for qualified education expenses. Talk to a tax advisor for the best way to take advantage of the exemption and avoid the penalty.

There is currently no time limit for taking withdrawals, so you can keep the money in the account in case your child decides to pursue an advanced degree later. Or you can switch the beneficiary of the plan to another eligible family member.

Do 529 Funds Impact Financial Aid?

Uncertainty about how 529 plans affect financial aid makes some parents hesitant to open an account. Hylland says a 529 plan owned by the parent or child will impact financial aid, "but the assets in a 529 plan factor less if the account is owned by the parents with the child as a beneficiary." This is because, for the purposes of calculating the expected family contribution, colleges consider only up to 5.6 percent of parental assets versus 20 percent of assets owned by the child.

Where to Enroll in a 529 Plan

Since plans can differ from state to state, research and compare different plans to determine which best fits your needs based on tax incentives, fees and investment options. Depending on the plan you choose, you can enroll directly through your state's 529 plan manager or through a financial advisor.

We encourage you to consult a financial planner when comparing savings accounts. You can also consult a tax professional for tax advice. Please also see IRS Publication 970 for more information or call the IRS at 1-800-829-1040 (TTY 1-800-829-4059).

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