I'm Donny. I'm a world traveler, investor, entrepreneur, and online marketing aficionado who has a big appetite to compete and disrupt big markets. I thrive on being able to create things that impact change, difficult challenges, and being able to add value in negative situations.
The cost of attending college continues to rise alongside the need for higher education degrees for many careers. This escalation means that many families are seeking opportunities to save for future educational expenses.
A 529 plan is a way to invest in your child’s future without paying excessive taxes on those funds.
Before investing in a 529 plan, you want to have all the information you need to make an educated decision about whether it’s right for your family. Read on to learn everything you need to know.
529 Plan Definition
A 529 plan, also known as a qualified tuition program, is a savings account that helps to fund a child’s college education. The name stems from Section 529 of the Internal Revenue Code that established these accounts in the mid-1990s.
How Does a 529 Plan Work?
A parent or grandparent can establish a 529 plan account to save for a child’s college expenses. The child becomes the primary beneficiary, but anybody can contribute.
Accumulated funds grow and are tax-deferred, and the child can make tax-free withdrawals to cover all qualified educational expenses. A 529 plan features investment options such as mutual funds and special portfolios, and you or your provider can select which ones you want to use.
Examples of a 529 Plan
As you explore 529 plans, it helps to have an idea of what to expect. Some of the most popular, established options come from Vanguard and Fidelity, which you can use as a starting point.
Vanguard offers several 529 plans, and its Education Savings Account is one of the most popular selections. On top of a competitive fee structure, you can contribute over $15,000 per beneficiary each year without incurring gift-tax consequences.
You can also select a range of investment portfolios, including some well-known mutual funds. Investment minimums start at $3,000, and there are no account maintenance fees for low balances.
Fidelity also offers 16 unique 529 plans to meet any family’s needs. Choose from a range of products, from high-risk investments to more conservative plans.
The firm also offers up to $4,500 in matching contributions for clients who set up automatic monthly contributions. You can expect competitive management fees compared to other firms in the class.
529 Withdrawal Rules
Rules for 529 plan withdrawals can vary, but you can only use them on qualified higher education expenses. Qualified expenses typically include tuition and fees, room, and board, books, supplies and equipment.
These funds can cover the cost of attendance at public or private colleges, accredited apprenticeship programs, graduate school or a professional program, such as medical or law school.
Additionally, it is possible to roll funds from 529 plans into ABLE accounts for beneficiaries with special needs. When you withdraw funds, they either go to the beneficiary’s personal account or to their educational institution.
If a beneficiary withdraws more than they spend in a given year, the remaining balance may fall under taxable income. Additionally, each state has separate rules about withdrawals.
For example, some states allow 529 plan withdrawals to fund K-12 tuition expenses. Check with your state’s guidelines to avoid any surprises.
529 Contribution Limits 2023
The Internal Revenue Service (IRS) limits 529 plan contributions every year. For 2023, the IRS has set the limit at $15,000 per beneficiary. Further, you can add $75,000 as a lump sum over five years without incurring gift tax.
Again, some states may have separate contribution limits, including some higher than the federal thresholds. To maximize contributions, you might have multiple family members invest to reach the yearly or lifetime maximums for each beneficiary.
Married couples might choose to file taxes separately so they can both make maximum contributions toward their child’s 529 plan.
Types of 529 Plans
Although all 529 plans have the same goal, there are two types to consider.
Education Savings Plans
An Education Savings Plan is a 529 plan that lets you save money for a beneficiary to use for education purposes, including K-12 tuition. Contributions come from after-tax dollars, but all earnings grow tax-deferred until the beneficiary withdraws them.
Investments shift to more conservative portfolios as the child grows up and are usually stocks, bonds, or mutual funds.
Prepaid Tuition Plans
Prepaid Tuition Plans let families purchase tuition credits at eligible educational institutions to make future attendance more affordable. These 529 plans guarantee the future cost of college tuition, so even if the tuition costs go up by the time your student plans to attend, you don’t have to compensate.
Consequently, prepaid tuition plans typically result in a discounted price for two- or four-year programs.
529 Plan Tax Advantages
The associated tax advantages make a 529 plan an attractive option for college expenses. Earnings are tax-deferred, meaning the IRS cannot tax the interest earnings.
The longer funds remain invested, the greater the growth potential through compound interest and investment returns. Tax deductions and tax credits vary by state, but many offer deductions and credits for 529 plans.
The federal government created the American Opportunity Tax Credit as a credit for higher education. You can claim a credit of up to $2,500 per year for qualified education expenses for each eligible student.
Withdrawals are also exempt from federal and state income taxes, meaning a student can use the account to pay for everything, from housing and dining/meal plans to textbooks and lab equipment.
Benefits of a 529 Account
A 529 plan offers numerous benefits for families planning on sending their children to college.
- No annual contribution limits – Families can contribute as much money as they want to maximize savings. Make small, regular contributions to keep up with inflation, and look for employers and other groups that offer matching contributions.
- Flexible plan location – Flexibility is one of the biggest draws for these plans because you can invest in your home state but apply the funds to any participating institution in the United States. However, most states offer incentives for choosing a program in your home state.
- Easy to open and maintain – Unlike other investment accounts, enrolling in a 529 plan is easy and requires limited maintenance. The account owner can apply online or by mail then maintain the account from any computer or smartphone. You don’t even need to worry about making important investment choices because they come in preset portfolios.
- No age limit for contributions or distributions – Another key feature is that there’s no age limit for contributions or distributions, and any family member can invest. Extended family members can help pay for school tuition in lieu of other gifts. Further, the beneficiary doesn’t have to reach a set age to withdraw funds. For example, students who graduate high school and enter college early can still access the money for educational purposes.
- Tax-deferred growth – The IRS doesn’t tax any interest earned on 529 plans, so money grows faster. Plus, you can expect fewer tax liabilities if you wait to make withdrawals.
- Tax-free withdrawals – Tax-free withdrawals apply to all qualified education costs as long as they follow IRS guidelines.
- Tax-deductible contributions – While you cannot include your 529 plan contributions as federal tax deductions, you might be able to claim them from the state where you live.
Disadvantages of a 529 Account
A 529 plan is not perfect, so prepare for the potential drawbacks to avoid unexpected issues.
- Cannot lock In tuition costs – While it would be nice to have an educational equivalent of rent control, 529 plans don’t offer a locked tuition rate. As college costs rise, your 529 plan may not cover as much as you hoped.
- Charges fees – Some 529 plan providers charge fees at various points. You might pay to start the account or incur maintenance fees along the way. Shop around to compare costs and fee structures.
- Limited investment options – Since they err toward the conservative side, 529 plans have limited investment options, usually only mutual funds and bonds.
- Different fee levels per state – Each state has different fee structures for 529 plans, including sub-account management fees, load fees and other miscellaneous expenses, such as annual account service charges.
- Must be used for education – You can only use 529 plan funds for educational purposes, or you will need to pay taxes and penalties. Funds must cover a student’s costs at an eligible institution, and there’s a set time frame to use the money.
- Restrictions on switching investments – Switching investments may or may not be possible in your state. Each state has its own regulations regarding 529 plans, so you need to know your home state limitations.
For example, switching investments could result in certain fees for some states, whereas others may allow changes at no cost to you.
How to Open a 529 Plan
It’s easy to establish a 529 plan as long as you have basic information on hand. Most states offer dedicated websites setting out the various options for your location.
- Choose a 529 plan.
- Determine the type of 529 plan account.
- Complete the 529 plan application.
- Fund the 529 plan.
- Choose investments for the 529 plan.
Is a 529 Savings Plan Worth It?
A 529 plan is an excellent way to save for school tuition and avoid financial aid with a lifetime of student loan repayments. There are notable tax benefits that make it lucrative for the account holder and designated beneficiary.
However, you may have to account for fees and deal with restrictions on schools. Carefully research your options to mitigate the drawbacks and capitalize on those benefits.
Overall, 529 college savings plans are effective solutions for paying for higher education.
529 plan FAQs
What happens to a 529 plan if a child doesn’t go to college?
If a child decides not to go to college, the family can change the account beneficiary to a different family member, use the funds for non-qualified expenses and pay the federal income tax penalty or choose to leave the funds in the account longer.
Can I have 529 plans from multiple states?
Yes, you can have 529 plans from multiple states. However, you need to understand each state’s plan restrictions and requirements, which may not be beneficial or practical.
Can I use a 529 plan outside of my state?
Yes, you can use a 529 plan in any state in the United States. However, most states offer incentives to stay at in-state schools.
Does a 529 plan affect financial aid?
Yes and no. A 529 plan can impact financial aid eligibility for need-based aid but not merit-based scholarships. You must report the 529 on the federal student aid application.
I'm Donny. I'm a world traveler, investor, entrepreneur, and online marketing aficionado who has a big appetite to compete and disrupt big markets. I thrive on being able to create things that impact change, difficult challenges, and being able to add value in negative situations.More Posts