529 Plan | Definition

Anyone can donate to a 529 plan, regardless of income or relationship.

529 plans are one of the most popular education savings accounts in the United States. They allow you to save for education while also providing other benefits. 

What is a 529 Plan?

A 529 plan is a tax-advantaged educational savings account. You can put money aside for your child, a family member, or even yourself. In addition to paying for books, school supplies, technology costs, and even student loan repayments, you can use your 529 savings to cover tuition and fees for your K–12 education, college, graduate school, trade school, and other expenses.

No matter where you live, you can participate in any state's plan and use your savings to cover eligible educational costs anywhere.

Recommended Read: Best Budgeting Tips as a College Student

Different Types of 529 Plans

There are many different types of college savings plans available, but 529 plans are typically classified as either prepaid tuition or college savings plans. Each of these plans works as follows:

College Savings Plans

College savings plans operate similarly to a Roth 401(k) or Roth IRA in that your after-tax contributions are invested in mutual funds or similar investments. There are several investment options available through the 529 college savings plan. The value of the 529 plan account will fluctuate depending on the performance of the investment options.

Prepaid Tuition Plans

Prepaid tuition plans allow you to pay for all or a portion of the costs of an in-state public college education in advance. They can also be used at private and out-of-state colleges. In addition, more than 250 private colleges sponsor the Private College 529 Plan, a separate prepaid plan for private colleges.

Educational institutions can offer prepaid tuition but not a college savings plan. The Michigan Education Trust (MET) was the first education savings plan and prepaid tuition plan. In addition, section 529 of the Internal Revenue Code was added, allowing qualified tuition programs to be tax-free. Currently, over 100 different 529 plans are available.

Recommended Read: These Four Employers Help Pay College Tuition Costs

Tax Benefits

Similar to a Roth 401(k) or Roth IRA, a 529 college savings plan invests your after-tax contributions in mutual funds, ETFs, and other comparable securities. Your investment increases tax-deferred and is withdrawable tax-free if used to cover eligible higher education costs. Federal income taxes cannot be deducted for contributions.

A state tax benefit is also available, depending on where you live. For contributions to 529 plans, more than 30 states provide state income tax deductions and tax credits. 529 plans are superior to conventional savings accounts or investment accounts for college savings because of these tax advantages.

Since contributions are considered gifts to the beneficiary, some families use 529 plans as an estate planning vehicle. As of 2023, the annual gift tax exclusion is limited to $16,000 per donor and beneficiary.

Selecting an Investment Plan for Your Child

Any state's plan allows you to set money ney aside, and you can use that money to cover eligible school costs anywhere in the world. Additionally, you can decide on the investment approach that best suits your comfort level. You can either select your asset mix or a target enrollment portfolio that gets more conservative as your beneficiary approaches their anticipated enrollment year.

Investment Goals

Each 529 plan provides investment portfolios tailored to the account holder's risk tolerance and time horizon. Your account's value may rise or fall depending on the performance of the investment option you choose. Before you invest, think about your investment goals and compare your options.

You should select a 529 plan based on your preferred investment strategy. With many 529 plan providers, you can have a lot of say in how your account is invested. There is no advantage or disadvantage to the state where your plan is sponsored as long as it is a nationwide 529 plan. The most important factors to consider when deciding on a plan are potential fees and the plan's track record of returns.

What is the maximum amount I can contribute to a 529 plan?

There are no annual contribution caps for 529 plans, unlike IRAs. Instead, your plan will determine the total amount you can contribute, but lifetime contribution caps generally range from $235,000 to $550,000 per beneficiary.

What if I am unable to make monthly contributions?

Most plans let you set up recurring automatic deposits from a linked bank account, but it's optional. After making the required minimum initial investment, you can make as many investments as you like whenever you want.

You can make one large donation around a birthday, a holiday, or any other special day. Gift contributions from family, friends, and other loved ones are also accepted for 529 plans.

Does financial aid affect a 529 plan?

In contrast to other savings accounts, like a UGMA/UTMA account, a dependent student's or one of their parents' ownership of a 529 plan account has a negligible effect on the student's eligibility for financial aid. This is because the Free Application for Federal Student Aid (FAFSA) treats assets held in 529 plans favorably, and distributions are not disclosed.

When a grandparent or other third party owns the 529 accounts, there might be a more significant effect on financial aid eligibility. This is because assets are not disclosed in this instance, but distributions are used to support the student financially by paying for college. Due to this, a student's eligibility for need-based aid may be reduced by as much as 50% of the distribution.

What happens to a 529 if my child doesn’t go to college?

The future is never guaranteed, so some parents worry that if their child receives a scholarship or doesn't attend college, they will lose the money they have saved in a 529 plan. There are some exceptions, but generally speaking, you must pay federal income tax and a penalty on the earnings portion of a non-qualified withdrawal. If the fine is dropped:

• The account beneficiary is given a full tuition tax-free scholarship.
• The beneficiary of the account studies at a U.S. Military Academy.
• Account beneficiary passes away or develops a disability.

The withdrawal's earnings portion will be subject to federal income tax and, occasionally, state income tax. Additionally, only the income earned in the 529 accounts will be subject to taxes and penalties, not contributions.

What happens to leftover money in a 529 plan?

If you want to avoid paying taxes and penalties on excess funds in your 529 plan, you can do the following:

• Replace the beneficiary with a different eligible family member.
• Keep the money in the account just in case the beneficiary decides to go to graduate school in the future.
• Pursue your education and fund your future.
• Transfer the money to an ABLE (529) account, a savings account created especially for people with disabilities.
• Since January 1, 2018, parents can withdraw up to $10,000 tax-free from their 529 accounts for K–12 tuition.
• Since January 1, 2019, beneficiaries and their siblings may each receive up to $10,000 in qualified distributions from a 529 plan to pay off student loans.

Any remaining funds in a 529 plan are available for withdrawal. However, unless you fall under one of the exceptions above, the earnings portion of a non-qualified withdrawal will be taxed and penalized. Be aware of the regulations and potential strategies for lowering taxes if you are considering making a non-qualified distribution.

Recommended Read: How To Make Your Child Rich Through a UTMA Account 

How to withdraw money from a 529 plan?

When you're ready to begin withdrawing funds from a 529 plan, most plans allow you to make payments directly to the account holder, the beneficiary, or the school. In addition, some plans may permit you to transfer funds directly from your 529 accounts to a third party, such as a landlord.

Contact your financial advisor about your 529 plan to learn how to withdraw distributions from your account. Depending on your circumstances, you may be required to report contributions to or withdraw from your 529 plan on your annual tax returns.

The Money Wrap-Up

A 529 plan may seem like the more obvious choice regarding college savings plans, given the many benefits. Most plans provide age-based investment options that automatically rebalance, taking more risk when your child is young and less risk as they get closer to college age. A 529 plan can be opened directly through your state's plan website or through some online brokers.