Key Takeaways
— 529 plans are state-sponsored accounts that offer tax-advantaged savings for education expenses; they cover college, trade and vocational courses, and qualified K-12 expenses.
— Recent expansions allow 529 funds for apprenticeship programs and student loan repayments without tax consequences or penalties.
— 529 plan funds are held at a brokerage, and owners can choose investments, adjusting risk levels based on the beneficiary’s age.
— Investors are not required to use their home state’s 529 plan and should consider fees, investment options and tax benefits when selecting a plan.
— Some states offer state income tax deductions or credits for 529 contributions.
If you like the idea of saving for education expenses while also getting tax-advantaged investment growth, consider a 529 plan.
A 529 plan is a tax-advantaged vehicle to save for college and trade and vocational courses participating in U.S. Department of Education student aid programs. You can even apply 529 funds to qualified K-12 expenses.
While parents and grandparents are typical 529 investors, you can open an account and name yourself or anybody else as the beneficiary. The account owner maintains control over the money in a 529 account until it’s withdrawn.
What Is a 529 Plans?
Just like its cousin, the 401(k), the 529 plan gets its name from the section of the tax code that created it.
These plans are designed to finance higher education, and their main appeal lies in their tax benefits and flexibility.
[Read: 10 Tax Credits You May Qualify for This Year]
The key feature of a 529 plan is tax-deferred growth. Earnings are not subject to federal income tax, which can help savers pile up cash for college.
Another attractive feature is tax-free withdrawals when the proceeds go toward qualified education expenses.
You can use the money you’ve socked away for a range of qualified education expenses, including tuition, room and board, books, supplies and certain K-12 costs.
“U.S. residents of all income levels can open a 529 plan,” Chris Urban, founder of Discovery Wealth Planning in McLean, Virginia, said in an email.
There are often federal or state tax advantages to saving in a 529 plan, he added.
“As long as money stays in the account, the principal and earnings will be federally tax-free, and possibly state tax-free, when withdrawn, provided the dollars are used on qualified education expenses,” Urban said.
What Are Prepaid vs. Savings Plans?
You’ll find 529 accounts in two flavors, prepaid and the vastly more popular savings plans, Ashley Weeks, a wealth strategist at TD Bank in Greenville, South Carolina, said in an email.
“Funds in both 529 account types grow tax-free, and future distributions are tax-free if used for qualified education expenses,” he added.
Prepaid plans, which are available only in a few states, are less flexible than savings plans.
“Prepaid tuition plans lock in future tuition at current rates through the purchase of tuition credits,” Weeks said. “These plans only pay for tuition and fees at certain covered colleges and often have state residency requirements.”
The main appeal of a prepaid plan is that locks in future tuition costs, which will increase with inflation at today’s prices. Students must use the funds at an in-state public college.
The 529 savings plans are more flexible, allowing beneficiaries to use the money at all qualified postsecondary schools, typically without a state residency requirement.
He added that 529 savings plans allow owners to select investments for the account and to tailor the risk level to the appropriate time horizon.
[See: Qualified Expenses You Can Pay for With a 529 Plan.]
How and Where Can I Spend 529 Funds?
Investors can use money from a 529 account for qualified higher education expenses, including tuition, room and board, books and supplies.
The funds can also cover up to $10,000 annually per beneficiary for K-12 education expenses.
Eligible institutions range from colleges and universities to vocational schools.
Recent expansions allow 529 funds to be used for apprenticeship programs registered with the Secretary of Labor’s National Apprenticeship Act.
The SECURE Act, signed into law in 2019, allows $10,000 from a 529 plan to go toward student loan repayment without any tax consequences or penalties. In addition, $10,000 can be applied toward student loan repayment for each of the account beneficiary’s siblings.
[Read: What Is the SECURE Act?]
Withdrawals from 529 plans can be used internationally, Patricia Roberts, chief operating officer at Phoenix, Arizona-based Gift of College, said in an email.
“To see which U.S. and international schools have a Federal School Code, an identification number used with federal financial aid program-eligible schools, check the U.S. Department of Education’s website,” Roberts said.
Note that there is a 10% penalty — plus income tax — that applies when you withdraw earnings from the account for nonqualified purchases.
Understand Your 529 Investment Choices
When you open a 529 account, your funds are held at a brokerage, such as Fidelity, Schwab or Vanguard. A financial advisor can also help you open a 529 account.
Once you’ve opened the account and funded it, you’ll choose the investments, such as mutual funds or exchange-traded funds. The investment options are similar to an IRA or 401(k).
Account owners have the option of investing the funds themselves or using a manager.
Many 529 plans use an age-based formula where investments gradually become more conservative as the beneficiary gets closer to college age. For example, if you open an account for a child when they’re five, you have more time to invest aggressively. When that child is in high school, a less risky investment mix will preserve capital so it’s available in a few short years when you need it.
“529 savings plans offer a range of investment choices, from conservative to aggressive portfolios,” Sean Lovison, founder and lead financial planner at Purpose Built Financial Services in Moorestown, New Jersey, said in an email.
Pay Attention to Fees
Investors often overlook account fees and expenses. That can be to your detriment, as seemingly small fees can add up, making less money available for education expenses.
Charges associated with a 529 account may include:
— Enrollment fee: Some plans charge you money to get your account up and running. Not every plan has this fee.
— Maintenance fee: Some accounts have a yearly maintenance fee. It’s typically minimal, coming in at around $50, but before opening an account, ask whether you’ll incur this charge.
— Expense ratios: All mutual funds and ETFs have some kind of management fee. The trick is to find the lowest fees on funds that align with your objectives. “Be sure to look at each fund’s expense ratio, as some states have pretty poor options, with very high fees compared to the better 529 plans,” Lovison said.
— Sales charge: A broker who’s not acting as a fiduciary can collect a commission for selling you a 529 plan. Currently, a registered investment advisor acting as a fiduciary can help clients open accounts and select investments for 529 plans sold directly through the states, but generally can’t access the account itself to manage the investments.
How to Select the Right State Plan
All 529 education savings plans are administered by states, but it’s important to note that you’re not required to use your home state’s 529 plan. You can choose from any available plans.
“When evaluating different 529 plans, the big three considerations are fees, investment options and state tax benefits,” Weeks added. “Fees vary widely between plans and the availability of low-cost funds and target date options can maximize 529 performance.”
Some states provide a state income tax deduction or tax credit when residents make 529 plan contributions, Weeks said.
It’s always a good idea to run your plans by a financial advisor or tax advisor to make sure you’re getting the maximum tax benefit. They may be aware of other options that may be more advantageous.
For example, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming don’t levy a state income tax, so a 529 deduction wouldn’t be applicable.
California, Hawaii, Kentucky and North Carolina have state income taxes but do not offer an income tax deduction or credit for 529 contributions.
Those tax rules can change over time. For example, in 2022, Delaware enacted a tax deduction for 529 contributions.
Rules, Regulations and Changes
Tax laws change, which is something investors need to keep in mind. While you might think of tax changes as resulting in more money out of your pocket, that’s not necessarily true when it comes to 529 plans.
For example, the 2017 Tax Cuts and Jobs Act allowed savers to use 529 plan funds for certain K-12 expenses.
The SECURE Act of 2019 allowed 529 funds to be used toward student loan debt payoff for an account beneficiary and their siblings (up to $10,000 per person). It also allowed 529 funds to go toward books fees and equipment used in a qualified apprenticeship program.
Another change became effective in January 2024. The SECURE 2.0 Act, which was signed into law in December 2022, now allows account owners to roll a lifetime maximum of $35,000 in remaining 529 funds into a Roth IRA in the beneficiary’s name. This eases concerns about overfunded 529 accounts.
Roberts called this “a new and welcomed additional feature, subject to various conditions, however.”
She pointed out that the 529 account must have been open for at least 15 years, and contributions made in the last five years are not eligible for a tax-free rollover. Also, Roth IRA rules, including annual contribution limits of $7,000, must be met.
In December 2023, there was another change to 529 withdrawal rules, specifically from accounts opened by grandparents. Previously, money from a 529 plan owned by a student’s grandparents was considered untaxed income for financial aid calculations. That sometimes reduced the amount of aid for which a student qualified.
Under the new rules, questions about cash gifts from grandparents have been removed from the Free Application for Federal Student Aid. The new FAFSA applications were launched in December 2023 in time for the 2024-25 academic year.
More from U.S. News
Ways to Save for Your Child’s College Education
How to Save Money for Your Kids
How to Pay for College Using These Overlooked Strategies
The Ultimate Guide to Understanding 529 College Savings Plans originally appeared on usnews.com
Update 01/31/24: This story was published at an earlier date and has been updated with new information.
