As the cost of higher education continues to soar, many families find themselves grappling with the daunting task of saving for their children's future academic endeavors. 529 plans are a popular—and potentially powerful—option for college savings. Put simply, 529 plans are tax-advantaged education savings vehicles, where the funds are for college only. However, like any financial instrument, 529 plans come with their own set of advantages and limitations.
How 529 plans work
A parent, grandparent, or any other individual can open a 529 account and name a beneficiary (usually a child or grandchild). The account owner can contribute money to the 529 plan. Usually states offer tax deductions or credits for contributions, though this varies by state.
The money in the account is invested in mutual funds, exchange-traded funds (ETFs), or other investment portfolios. Most 529 plans offer age-based options that automatically adjust the investment mix to become more conservative as the beneficiary approaches college age. The investments in the account grow tax-free at the federal level, and in most cases, at the state level as well.
When it's time for college, money can be withdrawn tax-free for qualified education expenses. These typically include tuition, fees, books, supplies, and room and board at eligible educational institutions.
If the original beneficiary doesn't need all the funds (e.g., they get a scholarship), the beneficiary can be changed to another qualifying family member without penalty.
However, if money is withdrawn for non-qualified expenses, the earnings portion of the withdrawal is subject to income tax and typically a 10% penalty. While there are no annual contribution limits set by the federal government, states may set lifetime contribution limits, which are typically quite high (often around $500,000 per beneficiary).
Starting this year, unused funds from a 529 plan can be rolled over into a Roth IRA for the account’s beneficiary without penalty. This new tax-free rollover rule—a part of SECURE 2.0—means you don’t have to worry about the current 10% penalty on the earnings if you end up with money left over.
529 plans owned by parents have a relatively small impact on federal financial aid eligibility compared to other types of assets.
Finally, it's worth noting that there are two types of 529 plans: savings plans (as described above) and prepaid tuition plans. Prepaid tuition plans allow you to pay for future tuition at today's rates at participating colleges, but they're less common and have different rules.
Pros of 529 plans
The primary advantage of 529 plans lies in their tax benefits. David Johnston, CFP and managing partner of Amwell Ridge Wealth Management, emphasizes that the tax-deferred growth and tax-free withdrawals are "massive benefits which magnify the longer the money is invested." This tax-advantaged growth can significantly boost the value of your education savings over time.
Additionally, 529 plans offer a unique benefit for scholarship recipients. As Johnston notes, "funds equal to scholarships received can be withdrawn penalty-free." This provision ensures that families aren't penalized for their children's academic achievements.
Plus, Johnston notes that recent changes have expanded their utility: "Several years ago, provisions were added to use up to $10,000 annually on non-post-secondary education costs, like grammar school or high school." Johnston explains further: "In addition to two- and four-year colleges and universities, funds can also be used towards accredited trade schools." This broadens the potential applications of 529 funds beyond traditional four-year institutions.
Another lesser-known feature is the ability to change beneficiaries. Johnston states, "People also aren't broadly aware beneficiaries can be changed (i.e. funds from Child 1 can be moved into Child 2's account)." This flexibility can be particularly useful for families with multiple children.
Cons and limitations of 529 plans
While 529 plans offer substantial benefits, they do have potential drawbacks. Johnston addresses a common concern: "The worst-case scenario is there are funds left over—you saved too much." In this case, there will be that 10% penalty explained above, plus your ordinary income tax on the gains.
However, he also offers alternatives to mitigate this issue: "You could hold on to the money for your grandkids, or use some of it to learn something new at a local community college." This highlights the long-term flexibility of 529 plans, even if immediate educational needs are met.
Making the most of 529 plans
With rising tuition costs, strategic planning is crucial. Johnston advises, "Various calculators are available to help you determine the future cost of education, which varies greatly by in-state, out-of-state, state institution, or private school."
Timing is also a critical factor: "Obviously the sooner you begin, the more you're able to take advantage of compounding." It's important to start to save early, allowing more time for investments to grow.
The bottom line
529 prepaid college tuition plans offer significant advantages for families saving for education, primarily through tax-advantaged growth and flexibility. However, it's important to carefully consider your family's specific circumstances and future educational needs when deciding how much to contribute. If you’re a parent and are looking to set up this college savings vehicle, start looking at online tools can help you compare different plan’s state-by-state offerings. Here’s our guide to opening a 529 for your kid.