How 529 Plans Work - And Why They’re Useful for College Savings

The rising cost of college has many parents wondering how they might be able to pay for their children’s education. It’s almost impossible to pay for school without some sort of long-term savings, financial aid, or student loans — or even all of these funding sources.

If you’re hoping to help your child pay for their college education, one way might be to start saving early with the help of a 529 college plan. These plans come with tax advantages and allow you to use the power of compounding returns to invest for the future. Let’s take a look at how 529 plans work.

How 529 plans work

A 529 plan is a type of tax-advantaged investment account designed for educational savings. In general, a 529 is considered a college savings plan, but it can also be used for some K-12 costs, as long as they meet certain requirements. Each state offers its own options for 529 plans and providers, but you aren’t required to invest in your home state’s plan.

Basically, the account holder designates a beneficiary or someone whom the contributions are made on behalf of. The account owner then makes contributions to the account and uses the money in the account to make investments meant to grow over time and pay for educational costs later. Learning how to invest money can be a way to make the most of a 529 plan.

Although there’s no federal tax deduction for 529 plan contributions, as long as the money is used for qualified educational expenses, it can be withdrawn tax-free. Some states do offer tax deductions so you'll want to see if your state offers a tax benefit before deciding which plan to invest in. Taxes don’t have to be paid on the gains and the beneficiary doesn’t have to include withdrawals in their income.

It’s worth noting that annual withdrawals can’t exceed the greater of the cost of attendance listed in the school’s financial aid calculations or the actual costs involved if a student is living off-campus. Also, there is a withdrawal limit of $10,000 per year for K-12 costs.

There are no set contribution limits for 529 plans. Instead, the IRS says they “can't be more than the amount necessary to provide for the qualified higher education expenses of the beneficiary.” 

Types of 529 plans

It’s important to understand how 529 plans work based on the type of account you choose. There are two main types of 529 plans designed to help you prepare to pay for college.

Education savings plan

With an education savings account, you save for general expenses. Funds from the plan can be used at a qualifying school — including K-12 institutions. With these types of plans, it’s possible to withdraw money to cover education costs even if the school isn’t located in your home state.

In many cases, you can choose from a variety of investment options — typically, mutual funds offered by the plan. There might also be cash-like instruments, such as money market funds or certificates of deposit. For example, the 529 plan I contribute to for my son’s schooling allows me to choose from a variety of stock and bond mutual funds, as well as investment money market funds. I can decide what percentage of the portfolio is invested in each fund and make automatic recurring contributions.

Fees for these types of 529 plans vary according to plan and the investments chosen. Each fund has its own expense ratio, and there might also be sales loads associated with the mutual funds. Check the expense ratios on offered funds, as those can eat into your real returns over time. On top of that, each plan administrator charges its own fees. These can range from $0 to more than $1,000 over a 10-year period.

Those who want more flexibility in how to use the funds (including changing the beneficiary on the account) are likely to benefit from this type of plan. Additionally, a 529 education savings plan can also be well-suited for those who want to be able to use the funds on other qualified education expenses such as books and computers used for college purposes.

Prepaid college tuition plan

Prepaid college tuition plans operate a bit differently. Instead of saving up for general college costs, these plans allow you to purchase credits for college tuition at today’s costs, helping protect against inflation.

However, it’s important to note that prepaid tuition plans are usually limited in terms of which schools a beneficiary can attend, usually based on public educational institutions within the state sponsoring the plan. Additionally, a prepaid tuition plan can’t be used to cover tuition at elementary and secondary schools.

Normally, you don’t have the ability to choose investments, and you can’t grow the account. There might be maintenance fees associated with the account, depending on the state involved.

These plans work best for those who are absolutely certain the beneficiary will attend a participating school and who are more interested in getting decreased tuition. However, for many people, a college savings plan could be a better choice, due to the flexibility.

The pros of 529 plans

• Useful college savings vehicle: Rather than coming up with money for college all at once, it’s possible to build college savings over time with investments and reduce the need for student loans.
• Tax advantages: Although there’s no federal income tax deduction for 529 contributions, you might get a break on your state income tax. Plus, when you withdraw the money, you don’t have to worry about capital gains taxes or having the money added to the beneficiary’s income.
• Pay for private school tuition before college: If you want to send your child to a private elementary or secondary school, you have the option to withdraw up to $10,000 a year from a 529 to cover qualifying tuition costs.
• Flexible college savings: It’s possible to change beneficiaries, pay for a variety of costs, and there are no age or income limits related to a 529 plan.
• Scholarship exception: If your child receives a scholarship, you can take a non-qualified withdrawal from the plan and avoid the 10% penalty as long as the withdrawal doesn’t exceed the scholarship amount. You still pay taxes on the earnings, however.

The cons of 529 plans

• Costs: Depending on the type of 529 plan chosen, there can be fees that eat into your real returns. However, there are low-cost plan choices available.
• Non-qualified withdrawal penalty: If you withdraw money for non-qualified expenses, you end up paying a penalty, plus taxes on the earnings. Once the money goes into the account, it’s supposed to be used for specific expenses.
• Federal financial aid impact: Depending on who owns the account and other factors, a 529 plan could impact the amount of your child’s financial aid when funds are withdrawn. This is especially true if a grandparent owns the 529 plan.

How to open a 529 plan

Opening a 529 plan account is fairly straightforward. You can compare plans across states and go through the process of opening an account when you find a plan that meets your needs. In addition to states, brokers like The Vanguard Group and Fidelity Investments offer 529 plans. The robo-advisor Wealthfront also offers a 529 college savings plan option.

Information you’re likely to need to open a 529 includes:

• Identifying information for both you and the beneficiary
  • Social Security number
  • Birthdate
  • Address
• Bank information (account and routing numbers) for funds transfers
• Investment choices (know what types of assets you want to include in the portfolio)

Once you open your plan, you can decide how much to contribute each month and set up a recurring contribution. This is one of the easiest ways to consistently grow a college savings portfolio for the benefit of your child.

FAQs

Alternatives to 529 plans for college savings

Before opening a 529 plan, it’s worth considering the alternatives. There are different ways to save for college and one might be more suitable for your circumstances than another. You can also choose to use multiple strategies and types of accounts to save for college. Carefully consider what makes sense for you before making a decision.

Roth IRAs

If you meet the income qualifications for a Roth IRA, you could potentially use some of the money for long-term savings. A Roth IRA is a tax-advantaged account you fund with post-tax dollars, and you can withdraw your contributions for any reason without paying an early withdrawal penalty or taxes. As long as the money is what you originally put in and not investment gains, you don’t have to worry about paying extra, which could give you flexibility in how you use the money.

Additionally, you can withdraw money from a Roth IRA for qualified education expenses without paying the 10% early withdrawal penalty. However, be aware that if you dip into earnings, you still have to pay taxes on the amount. You won’t pay taxes on investment earnings from a 529 plan if the money is used for qualified expenses.

High-yield savings accounts

There are no restrictions on withdrawing your money from high-yield savings accounts, so you don’t have to worry about qualified expenses. This can be a way to set aside money for college, as long as you have a long time frame. With a high-yield savings account, you won’t have access to the potential returns that come with an investment account.

Finally, understand that you will pay taxes on interest earned during the year. However, you report your interest earnings annually and pay applicable taxes when the interest is earned, rather than when you withdraw money from the account. You don’t have to pay taxes on money you withdraw from a high-yield savings account.

Taxable accounts

If you want access to potential investment gains without the restrictions associated with a tax-advantaged account, a taxable investment account might be one way to save for college. You can choose your investments and then withdraw the money at any time when you focus on taxable investment accounts. In fact, you can usually hold individual stocks and other investments you might not have access to if you open a 529 plan.

However, you will pay taxes on your earnings. Pay attention to whether you have long-term or short-term capital gains before withdrawing money for college. You may also use investing losses to offset some of your capital gains taxes.

Custodial accounts

Finally, you can set up a custodial account on behalf of your child to help them save for college. These accounts, unlike some other accounts you might have, are actually owned by your child, even though you’re responsible for managing the accounts while your child is a minor. Once your child reaches the age of majority, they have legal access to and control over the accounts and can make decisions without you.

Additionally, custodial accounts can impact your child’s financial aid, so it’s important to be aware of the situation before setting up an account like this. And depending on the account, taxes and penalties might apply.

The bottom line

Learning how 529 plans work for college savings, and understanding how they might be able to help reduce your child’s reliance on student loan debt can help you provide a way for a student to get an education without breaking the bank.

Carefully consider your options and think about whether investing using a 529 account could potentially help pay for college, especially with the flexibility that comes with beneficiaries and uses for the account.

FinanceBuzz is not an investment advisor. This content is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.