Saving for college with a 529 plan

With college costs on the rise, many parents feel a sense of urgency to save for their child's education. One popular way to do that is through a 529 plan. This is a tax-advantaged account that allows you to set aside money for qualified college expenses. Many of the benefits of a 529 plan are outlined here—however we encourage you to consult a financial advisor or tax professional for guidance about the specific rules and regulations that apply to you.

What is a 529 plan?

A 529 plan is a college savings plan that can be used to cover qualified education expenses beyond tuition. They offer unique tax advantages that are meant to make saving for college a little easier, which is no small thing. For the 2022-23 academic year, the average tuition and fees for a full-time student at a public four-year, in-state college is $10,950, according to the College Board.

529 savings plans are structured as investment accounts, and savers can usually choose from a range of investment options. For example, asset allocation may be set up to be more aggressive when the child is younger, then gradually become more conservative as they get closer to graduating high school. That way, the closer the student gets to starting college, the more stable the investment portfolio.

What are the benefits of a 529 plan?

Saving for college with a 529 plan unlocks a number of federal and state tax benefits.

• Investment earnings are generally not subject to income taxes each year. That means the investments grow tax-free.
• If the funds are eventually used for qualified education expenses, those withdrawals aren’t subject to federal income taxes. (State tax rules vary.)
• Many states offer a state income tax deduction or credit for contributions made to a 529 plan. Often, the state's tax benefits are only available if you fund an in-state plan.
• The child is named as the 529 plan beneficiary. If they end up not going to a qualifying school, you can change the beneficiary to another eligible family member and avoid taxes and penalties.

What qualified expenses does a 529 plan cover?

To be eligible for tax-free withdrawals, 529 plan funds must be used for qualified expenses at a college, university, vocational school or other eligible post-secondary institution. Those expenses typically include:

• Tuition and fees
• Books and supplies
• Room and board
• Mandatory equipment such as a computer, computer software, or Internet access

What are the different types of 529 plans?

Sponsored by states, state agencies, or educational institutions, there are two types of 529 plans to choose from:

• 529 savings plan: This 529 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, exchange-traded funds (ETFs), or other investment vehicles. The account value goes up or down based on how its investments perform. Some 529 plans have a minimum opening contribution, so be sure to understand the fee structure before enrolling. Once it’s open, you can choose to contribute small amounts each month or make lump-sum contributions on your own schedule.
• 529 prepaid tuition plan: This 529 plan allows you to prepay college tuition and lock in today's prices. The beneficiary can then 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 your in-state tuition and fees. The student or parent will be responsible for paying the difference.

Matt Hylland, a financial planner, says some families prefer 529 savings plans because they are able to save in small increments. Prepaid plans, on the other hand, 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."

What are 529 plan contribution limits?

The IRS doesn’t specify a dollar amount for annual contribution limits to 529 plans. But because 529 plan contributions are considered gifts for tax purposes, large contributions to a 529 plan could require you 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 my child doesn't need 529 plan funds?

You can change the beneficiary on your 529 plan if your child chooses not to attend a qualifying school and you may have other options if your child gets a scholarship. Under most circumstances, you’ll incur a 10% penalty if you use 529 plans for anything other than qualified education expenses in addition to being responsible for state and federal income taxes. The silver lining is that if your child gets a scholarship, that 10% penalty is waived for withdrawals up to the scholarship amount. However, income taxes on earnings will still apply. Talk to a tax advisor for the best way to take advantage of this exemption and avoid the penalty.

There is currently no time limit for taking 529 plan withdrawals. That means you can keep unused funds in the account in case your child decides to pursue an advanced degree later. Alternatively, you can switch the beneficiary of the plan to another eligible family member.

Do 529 funds impact financial aid?

Some parents may be hesitant to open a 529 plan because they’re worried about how it might affect their child’s financial aid eligibility. Hylland says it does play a role, but the impact is less severe if the 529 plan is owned by the parents with the student listed as the beneficiary (instead of the student being listed as the account owner account).

For the purposes of calculating the Expected Family Contribution (EFC), colleges only consider up to 5.6% of parental assets—versus 20% of assets owned by the child.

How can I enroll in a 529 plan?

529 plans can vary from state to state, and you can choose a plan from a state other than your state of residency. Researching and comparing different plans can help you determine which one best fits your needs based on tax incentives, fees, and investment options. Depending on the plan you choose, you can likely enroll directly through the 529 plan you choose or through a financial advisor.