This tax-advantaged savings account can help you pay for higher education expenses.
Published April 2, 2020|8 min read
A 529 plan lets you prepay tuition or invest money for college costs
You can withdraw unused money in a college savings plan, but you'll pay a penalty if you don’t spend it on qualified expenses
Living in one state does not hinder you from opening a 529 plan sponsored by another state
Students may still qualify for financial aid with a 529 savings plan
The cost of college continues to rise and shows no signs of slowing down. A 529 plan can help parents save for their child’s higher education. One type of 529 plan lets you save on tuition by paying for it ahead of time. But another more common type of 529 plan lets you open a tax-advantaged investment account to earn money to pay for education expenses down the line. The way it works is you fund money into the plan account, which gets invested in securities, like stocks and bonds, and grows until it’s time to make a withdrawal.
College savings plans come with certain tax advantages, with some states offering more generous tax benefits than others. 529 plans are offered and administered by each state, but depending on the type of plan you want, you may not have to open one in the state where you live. That leaves you with a lot of options when it comes to setting up a 529 plan. We’ll talk about how a 529 college savings plan works and how to open one.
Officially known as a qualified tuition program, 529 plans come in two different types: prepaid tuition plans and education savings plans. The latter is more common and what most people think of when they hear about 529 plans.
Prepaid plans let you buy future college tuition credits at today’s rates, effectively 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 collect a refund or change the beneficiary. (Some plans let you apply your prepaid tuition across state lines.)
The benefit of prepaid plans is you’re safeguarding against the rising cost of tuition. Prepaid plans typically only cover the certain college costs like tuition and fees, but not anything else.
Only a limited number of states offer prepaid plans, and some of those are closed to new participants.
A 529 education savings plan is a tax-advantaged investment account designed to help parents, guardians or loved ones save for a child’s education. The money you contribute to a 529 college savings plan can grow tax-deferred and withdrawals are tax-free so long as you spend the money on qualified expenses.
Qualified educational expenses include tuition and fees at public and private universities, trade schools, and vocational schools. As of 2018, savings plans cover private primary and secondary education expenses, not just higher education expenses. They can also include room and board, textbooks, computers, and other school supplies.
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The money in a college savings plan is invested into stocks, bonds, mutual funds, and other securities that grow until the beneficiary withdraws the money to pay for qualified education expenses listed above.
With a 529 investment plan you can manage the investments yourself, or get a plan with an automatic investment strategy . These 529 plans make age-based investments, reallocating them from high-risk, high-opportunity investments to more conservative ones as time goes on and the closer the beneficiary is going to college. This option is a good fit for people who want to “set and forget” their 529 plan. People with more investing experience or a financial advisor might prefer a custom 529 plan that offers greater control and lets you create and manage your own investment objectives.
The biggest upside to 529 investment plans are the tax advantages, like tax-deferred growth on assets. The 529 plan operates similarly to a Roth IRA, a tax-advantaged retirement plan. The money that you put in the plan account doesn’t get any special federal tax benefits, like a federal income tax deduction, but when you make a qualified withdrawal you won’t have to pay any income tax or capital gains tax on it. Speak with a tax advisor if you have more questions.
The FAFSA form takes into account both the student and parent’s income and assets when assessing need-based financial aid. If the parent owns a 529 plan and claims the beneficiary as a dependent on their taxes, it may affect how much financial aid the beneficiary receives. However, the impact may be limited, depending on how much is in the plan account and other assets that the parent might hold.
Let’s say you open a 529 education savings account now. Given the current trend of rising college costs, it’s possible that the cost of the tuition will be higher still in the future when you withdraw the money. That means the money in your plan account must also grow at a greater rate, but this isn’t guaranteed. A 529 education savings plan may not generate as high of a return as you had hoped. This might happen because you didn’t invest aggressively enough, or the market does poorly and your investments lost value, or simply because the price of college skyrocketed so much it wiped out any potential savings.
With an education savings account, you’re hoping that the money you contribute grows faster than the cost of tuition to make it more worthwhile over a prepaid plan. If it doesn’t, then a prepaid plan may serve you better since you can lock in today’s price. However, you run the opposite risk with prepaid plans — if you buy college credits now, and the costs of tuition goes down in the future when you need to make a qualified withdrawal, then you will have lost money.
With a prepaid plan, you are betting that tuition prices will rise in the future. With a 529 plan, you’re betting that your investments will grow at a higher rate than that of college costs. Keep in mind other differences between the plans, like the flexibility offered by the savings plan when it comes to spending the money.
Once you’ve decided on a 529 plan type, you need to choose which state you want to work with. If you go with a prepaid tuition plan, in most cases you or your child will have to be a resident of the state. However, education savings plans do not require in-state residence. Make sure to research the tax benefits your state offers for 529 contributions.
State plans differ in terms of contribution limits and investment options, and many provide a state tax deduction for contributions. (Remember: you cannot get a federal income tax deduction.)
If you don't get tax advantages in your state, you might choose a state plan with low costs and strong investment options.
Check out our state-by-state guide to 529 college savings plans to get started.
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. You will need to provide information about yourself and the beneficiary, including mailing address, Social Security number, and birth date. You may need to provide banking information.
Remember, very few 529 plans allow joint ownership, so you will probably name yourself as the sole owner. (If you’re married and the plan is for your child, this account could become contentious in the case of divorce.) Of course, each parent can set up their own 529 plan, even if they file jointly on their taxes. You can also transfer your account to another owner at a later date.
Just like when you set up a life insurance policy, you will have to name a beneficiary for the 529 plan account. You can name anyone as a beneficiary — a child, relative, friend or yourself. You can always change the beneficiary at a later time.
529 applications will ask 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.
Some 529 plans charge an application fee, and some require a minimum initial contribution. Be prepared to pay. We’ll talk about making contributions next.
Once your prepaid or 529 investment plan account is open, anyone can contribute to the account, including friends and family. Most plans will let you contribute via check as well as one-time or automated monthly bank transfers.
Each state may impose a total contribution limit for 529 plans. The federal government doesn’t set any contribution limits, but there are tax implications if you exceed a certain limit. In 2020, individual contributions of up to $15,000 per beneficiary are exempt from the gift tax so if you contribute more, you will have to report it when you file your taxes.
One way to maximize your contributions without reaching your gift tax limit is to have friends and relatives contribute to the 529 plan in lieu of traditional birthday or holiday gifts. Friends and family can also start their own 529 plans for your student.
If the beneficiary decides not to go to college, you can transfer the plan 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 federal and state income tax.
Education savings 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 prepaid tuition 529 plans, the funds may not transfer over when you move.
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