What is a 529 college savings plan and how it works

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A 529 plan is a tax-advantaged savings plan that allows you to pay for education expenses.

This college savings plan allows any contributions to the account to grow tax-deferred. Money can be withdrawn tax-free as long as it’s used for qualified education expenses, such as tuition and fees, room and board and books at universities as well as technical and vocational schools. While created to help pay for college, these plans can now also be used to pay for K-12 tuition at private schools.

So, what is a 529 plan? Here’s what you need to know about 529 plans and how to use them to achieve your future college savings goals for your children.

How 529 plans work

A 529 plan allows a participant to set up a tax-advantaged account to allow a beneficiary to use the funds for qualified education expenses. The participant deposits after-tax money in the account. The money in the account can grow tax-deferred and then be tapped tax-free for relevant expenses.

A 529 plan may even reduce your taxes today in some cases. Some states offer tax deductions on contributions, and you can calculate your potential contribution with the help of Vanguard’s 529 state tax deduction calculator. Contributions are made with after-tax money, so they won’t earn you a federal tax deduction, however.

Anyone can establish a plan and contribute to it. Parents, grandparents and other relatives can all open and contribute to the account. You can even fund your own educational expenses this way. You might not even have to be the owner of the account to claim a tax deduction for your contribution, though it depends on the state’s laws

When you withdraw the money from your 529 plan, you should use it on education expenses in that same calendar year. Otherwise, you’ll be making an unqualified withdrawal that will cause the IRS to take notice, since you won’t be using the funds. Be sure to keep any receipts, should the IRS come calling.

Various state plans have different benefits, and it can pay to look around and find the best plan for you. You’ll want to look for low cost, good investment returns and good benefits. The rules for each state plan differ, so you need to know the specific rules for your plan.

What are the different types of 529 plans?

The 529 plan has two major types: a prepaid tuition plan and an education savings plan. They each serve different needs and offer different investment methods.

  • A prepaid tuition plan lets you buy college tuition credits to use in the future at today’s prices. A 529 participant can purchase these credits only at participating colleges and universities for the plan’s beneficiary. These credits can’t be used for room and board and aren’t available for primary and secondary schools.
  • An education savings plan is more encompassing and it allows you to open an investment account that can be tapped in the future for education expenses. These plans pay for tuition and fees, room and board, books and other qualified costs. This account can generally be used at almost any U.S. college or university and can also be used for K-12 private education.

The education savings account can be invested in many different assets including potentially high-return options such as stock funds, as well as lower-return but less risky options such as bond funds and even money market funds. However, if it’s invested in the market such as in stock funds or bond funds, its value is not insured by state or federal governments.

Tax and financial aid benefits

The 529 plan can offer several tax and financial aid benefits to participants:

  • Grow your contributions on a tax-deferred basis. You won’t pay taxes on any earnings in the account, so long as you maintain the money in the account.
  • Tax-free withdrawals for qualified education expenses. Your tax-deferred gains become tax-free gains, if you use the money for qualified education expenses.
  • Potential state tax deduction. Save on taxes if your state offers a break on deductions. However, you won’t get a state tax deduction for a state where you don’t pay taxes.
  • Beneficiaries can change over time. A 529 plan can work for multiple kids, if they don’t need to use the program at the same time. Plan ahead to avoid potentially violating a plan’s rules.
  • Student loan repayment. At the end of 2019, Congress authorized funds in a 529 to be used for loan repayment. Up to a total of $10,000 can be used to pay back student loans, and as much as another $10,000 can be used to pay loans for a beneficiary’s siblings.
  • Accounts owned by parents have a lower impact on financial aid. Assets owned by your child can reduce their financial aid eligibility by a large amount. However, a 529 plan isn’t owned by the child, so an account owned by parents can have a smaller impact (this isn’t true of grandparent-owned accounts, however).

How to use a 529 plan for multiple children

It’s possible to use a single 529 plan for the benefit of multiple children. For example, if your children’s ages are more than four years apart, you may be able to change the plan’s beneficiary after the first child graduates. If you do this, however, you might want to factor in how much money is left in the plan for the second (or third) child once it’s been tapped by an earlier child.

Moreover, using just one plan may make the 529 plan less valuable for later children. For example, if you switch to more conservative investments as the first child nears college, then it may deprive the second child of potential future returns from more aggressive investments depending on how it’s allocated.

Depending on your situation, it may make more sense to have a separate 529 plan for each child. In addition, this approach allows you to keep better records and may offer you an additional chance for a state tax deduction if your state offers one.

What is and isn’t covered by a 529 plan?

It’s important to understand that you can only access your money on a tax-free basis if you spend it on qualified education expenses. Anything that doesn’t fit the IRS’s interpretation of a qualified expense will likely see the agency slapping a penalty on your withdrawal.

Anything not specified by the IRS in its definition of a qualified expense is likely not covered.

The IRS specifies that qualified expenses must be “related to enrollment or attendance at an eligible post-secondary school.” Moreover, the IRS says that “to be qualified, some of the expenses must be required by the school and some must be incurred by students who are enrolled at least half-time.”

  • Tuition and fees charged by the institution.
  • Textbooks required by enrolled classes.
  • Room and board, not to exceed the amount listed by the school as part of the cost of attendance.
  • Computers and software, and other equipment, that are used primarily for educational purposes.
  • Apprenticeship costs as long as the program is registered with the U.S. Department of Labor.
  • Up to $10,000 in K-12 private education tuition expenses.
  • Special needs services, provided that they are incurred as part of attendance at the school.
  • Up to $10,000 in student loan repayment.

You will not be able to use a 529 penalty-free to pay for transportation costs at college or to pay extracurricular fees.

How to start a 529 plan

If you’re looking to open a 529 plan, you can do that directly through a state’s plan. But you also have the option of going through a broker or financial advisor who may be able to assist you with the plan.

  • When you go directly to a plan’s website, you need to register, analyze the potential investments and then manage the plan over its lifetime. You’ll be overseeing the plan and dealing with any issues that arise.
  • When working with a broker or financial advisor, you can have your agent do the heavy lifting: finding the best state plan for you, selecting the funds and overseeing the program. A broker or advisor may also be able to give you further advice on the program. But you’ll pay for this extra level of service with either a sales commission or higher investment fees.

Can you use a 529 plan at any college?

A 529 savings plan can be used at any qualified college nationwide. Most states do not limit the availability to states that sponsored your 529. For example, you might contribute to an account set up with one state’s plan, but still be able to use the funds at any qualified institutions of higher learning.

Prepaid tuition plans, on the other hand, are often more limited in scope. They can usually only be used at specific colleges. Some state prepaid tuition plans allow for the credits to be used at multiple public institutions in the state, but you might not be able to use the credits outside the state.

Double-check to see that your institution qualifies, however, since not every college does.

What happens if my child doesn’t use the 529 plan?

If your child opts not to go to college or other vocational school, the beneficiary can be changed to another family member who might be able to use the money. In general, the plan can continue holding the funds indefinitely as long as it has a living beneficiary listed.

However, eventually if the money can’t be used, it must be withdrawn. If the money isn’t used for qualified educational expenses, you’ll have to pay taxes on the earnings, as well as a 10 percent penalty.

However, there are ways to get the money back without paying the 10 percent penalty (although you may need to pay taxes on earnings):

  • Scholarship. If the beneficiary received a tax free scholarship, you can withdraw money to the amount of the scholarship.
  • US military academy attendance. This is treated as a scholarship.
  • Beneficiary death. If the designated beneficiary dies, the amount can be withdrawn.
  • Beneficiary becomes disabled. A physician must certify that the beneficiary can’t complete gainful employment.
  • Employer education assistance. If an employer offers assistance, that amount can be withdrawn without paying the penalty.

Where did 529 savings plans originate?

The 529 plan originated in 1996 and took its name after Section 529 in the Internal Revenue Code, which authorized qualified tuition programs to provide tax-free benefits to savers. The plan has its origins in Michigan’s 1986 decision to offer prepaid tuition plans to state colleges.

What counts as a qualified expense has expanded over the years. In 2015, the plan began to include computers as a tax-free expenditure, while 2017 saw the program include K-12 tuition of up to $10,000 annually. In 2019, the plan expanded further to include loan repayment, mentioned above, as well as the option to use a 529 plan to pay for apprenticeship programs.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
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