Updated April 12, 2019: The cost of college continues to rise and shows no signs of slowing down. A 529 college savings plan can help parents save — and, ultimately, pay — for their child’s higher education. However, there are multiple types of 529 plans, which can make selecting and opening one overwhelming. We can help you through the process. Here’s how to set up a 529 college savings plan.
What is a 529 plan?
A 529 plan, also known as a qualified tuition program, is a tax-advantaged savings/investment account designed to help parents, guardians or loved ones save for a child’s education. Contributions to a 529 plans are not exempt from federal taxation, but the earnings on your investments are tax-deferred and withdrawals are tax-free so long as you spend the money on qualified expenses.
Qualified expenses include tuition and fees at public and private universities, trade schools, vocational schools, and, as of 2018, private primary and secondary schools. They can also include room-and-board, textbooks, computers, computer software and other school supplies.
529 plans are offered and administered by the states. Each one (except Wyoming, which participates in Colorado’s plan) offers a 529 plan, and some states offer multiple options. You don’t have to open the 529 plan offered by your state, but you probably want to if your state offers income tax benefits to its account holders.
The types of 529 college savings plans
529 college savings plans come in two different types: prepaid tuition plans and investment plans.
Prepaid tuition plans
Prepaid plans let you buy future college credits at today’s rates, locking in the cost of tuition. You select the number of semesters or college credits you wish to buy, and pay for them at once or through installments. Many prepaid tuition plans are restricted to in-state residents and must be used for in-state schools, but you won’t lose money if the beneficiary decides to attend school out of state. You can change the beneficiary or collect a refund. (Select plans let you apply your prepaid tuition across state lines.)
The main upside of prepaid plans is you’re safeguarding against the rising cost of tuition. In addition, you aren’t taking a risk, like you would with an 529 investment plan. The downside is prepaid plans typically only cover the cost of tuition and fees, not room and board or textbooks. Only a limited number of states offer prepaid plans, and some of those are closed to new participants.
529 college savings investment plans
Investment plans are much more common than prepaid plans — and what you commonly think of when you hear the numbers 529. Contributions to a 529 college savings investment plan are rolled into a portfolio of stocks, bonds and other securities that grows until the beneficiary withdraws funds to pay for college. As long as funds are used for qualifying expenses, all investment growth is tax-free. Investment plans are more flexible, and can be used for tuition and fees, room and board, textbooks and other qualifying expenses.
There are two types of investment 529 plans:
Age-based 529 plans: Age-based 529 plans gradually reallocate investments, shifting from high-risk, high-opportunity investments to conservative investments as time goes on. These reallocations occur automatically and reduce your risk of losing your money to an economic recession or bad investment as the plan matures. This option is a good fit for people who want to “set and forget” their 529 plan.
Custom 529 plans: Custom 529 plans offer greater control, letting you create and manage your own portfolio. These plans are suitable for individuals with investing experience who don’t mind actively managing the account. While they may be more risky than age-based 529 plans, they have greater potential for rapid growth.
The main upside of 529 investment plans is the potential for tax-free growth over time. Plus, they can be used to pay for more types of educational expenses than prepaid plans.
“The income and capital gains generated by the assets held in the custodial account are not subject to federal tax, so long as the distributions are used to pay for qualified education expenses,” said Ryan Firth, a Certified Public Accountant and president at Mercer Street, a financial and tax services firm.
How to choose a state 529 college savings plan
Once you’ve decided on a 529 plan type, you need to choose which state you want to work with. Contrary to popular belief, you can participate in most 529 plans across state borders. Some plans, particularly prepaid tuition plans, require in-state residence. Make sure to research the tax benefits your state offers for 529 contributions.
“Many states provide a state tax deduction for contributions,” said Philip H. Weiss, Certified Public Accountant and principal at Apprise Wealth Management. “That benefit is typically only available if you contribute to the plan in your state of residence.”
State plans differ in terms of contribution minimums, maximums and investment options. Check out our state-by-state guide to college savings plans to find out the major terms, conditions and tax breaks associated with the investment and prepaid tuition plans offered by your state.
“When choosing plans, you should pay attention to the underlying costs and expenses associated with the plan as well as the types of funds you can invest in,” said Weiss. “If you don't get a state tax deduction for contributions, the most common choice is usually Utah, as the costs are low and the investment options are strong.”
In other words, look for low-fee plans with quality investment options. If you need help choosing a 529 plan, consult with a financial adviser.
How to set up a 529 plan
Once you’ve chosen a 529 plan, you’ll have to enroll with the state’s designated administrator. These administrators are essentially investment managers for your 529 contributions. Applications can usually be completed online or by mail. When opening the plan, be prepared for the following:
Paperwork: You will need to provide personal information that may include your mailing address, Social Security number and birth date. You may need to provide banking information. You will also need to provide personal information for the beneficiary.
Naming a beneficiary: Just like when setting up a life insurance policy, you will have to name a beneficiary for the account. You can name anyone as a beneficiary — a child, relative, friend or yourself. You can always change the beneficiary at a later time.
Successor: 529 applications will invite you to name a successor, who will manage the account if you die or become incapacitated. It may be optional, but it’s a good idea to designate someone you trust. If you don’t name a successor and something happens to you, the new owner may be decided in probate.
Fees and Contributions: Some 529 plans charge an application fee, and some require a minimum initial contribution. Check your plan’s requirements and be prepared to pay.
Remember, very few 529 plans allow joint ownership, so you will probably name yourself as the sole owner when you submit an application. If you’re married and the plan is for your child, this account could become a bone of contention in the case of divorce. Of course, each parent can set up their own 529 plan. You can also transfer your account to another owner at a later date.
How to contribute to a 529 Plan
Once your prepaid or 529 investment plan is open, anyone can contribute to the account, including friends and family. (Here's some extra tips for grandparents looking to set up a 529 plan.) Most plans will let you contribute via check, one-time bank transfers or even automated monthly contributions.
“You can contribute to a 529 plan either by direct withdrawal from your bank account by sending a check to the plan sponsor for deposit into the account,” said Weiss.
The government doesn’t limit how much you can contribute to a 529 plan, but there are tax implications if you exceed a certain limit. In 2018, individual contributions of up to $15,000 per beneficiary are exempt from the gift tax. If you contribute more, you will have to report it for gift tax purposes when you file in 2019.
“Individuals contributing to a 529 plan should be aware that the annual gift tax exclusion applies, which for 2018 is $15,000 per beneficiary. Gift-splitting is possible, so a couple can give a total of $30,000 to each child in 2018,” said Firth. “Super-funding is also possible with 529 plans, whereby five years of gifting can be made in one year.”
The state may also impose a maximum total balance for its 529 plan.
If you really want to maximize contributions, have your friends and family contribute to the 529 plan in lieu of traditional gifts for birthdays, holidays and more.
What happens to a 529 plan if your child doesn’t go to college?
If the beneficiary decides not to go to college, you can transfer the account to a new beneficiary or withdraw the funds. Withdrawals not used for qualified educational expenses will be subject to a 10% federal penalty tax, and any investment growth will be subject to income tax.
If the beneficiary receives a scholarship, you can use your 529 plan to make up the difference, or withdraw the funds.
What happens to a 529 plan if you move?
Most 529 plans allow you to continue to participate after you move to a different state, although you may not continue to receive state tax benefits.
For answers to common questions regarding 529 plans and their tax implications, check out the IRS 529 FAQ page.
You can use Savingforcollege.com’s research tool to compare 529 plans state by state.
Looking for financial aid? You can read more about federal assistance for tuition and fees at the Department of Education’s Student Aid website.
The Financial Industry Regulatory Authority website has more information about 529s and other college saving options.
Want more money tips on the reg? Sign up for the Policygenius newsletter.