Learn the ins and outs of 529 plans and why they’re a popular savings vehicle for paying for college.
A 529 plan is among the most powerful tools available when it comes to saving money for education — one that can provide benefits for tax-advantaged investing, estate planning and more.
As you navigate your college savings journey, we will help you understand how a 529 plan can help you reach your student’s education goals and find the right account that can serve your family’s needs. Here are answers to frequently asked questions about 529 plans:
In this article
What is a 529 plan?
529 plans are tax-advantaged savings plans set up by states to help pay for education.
Originally created to help parents save money for their children’s college expenses, 529 plans can also be used to pay for apprenticeship programs, education loan payments, certain K-12 education costs and lifelong learning. They can also be beneficial for estate planning.
What types of 529 plans are there?
There are two types of 529 plans: savings plans and prepaid tuition plans.
- Savings plans allow you to contribute after-tax money into an investment account on behalf of a designated beneficiary (usually your child, but it could be a grandchild, niece, nephew, family friend or even yourself). The money grows tax-deferred. Withdrawals are tax-free if the distributions are used for qualified education expenses.
- Prepaid tuition plans let you pay in advance for tuition at designated public and private colleges and universities at today’s prices, helping to manage future costs. All 50 states and the District of Columbia currently sponsor at least one type of 529 plan, though prepaid tuition plans are less common and not available through financial advisors. As of 2023, the only states to offer prepaid tuition plans are Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas and Washington.
Because prepaid tuition plans are increasingly rare and not widely available to investors, this article will focus specifically on the dynamics and intricacies of 529 savings plans.
What are the biggest benefits of a 529 plan?
The most significant benefits are:
- Tax advantages: Contributions are made with after-tax dollars1 and earnings in a 529 plan compound annually free of federal and generally state taxes. In addition, withdrawals for qualified education expenses are tax-free.
- Flexibility and convenience: There are no income limits for contributors, and no age limits on beneficiaries. You can also enroll in any 529 plan regardless of where you or the beneficiary lives. Most plans also have low investment minimums and high contribution limits (up to $400,000 or more per beneficiary).
- Control: The owner of the 529 plan retains full control over the account. The owner can change the designated beneficiary, without incurring tax or penalties, if the new beneficiary is a family member of the old beneficiary. The owner can also change 529 plan investment options twice per year.
- Potential to use leftover funds to jump-start the beneficiary’s retirement savings: Beginning in 2024, beneficiaries of 529 plans that have been in place for 15 years or more can transfer assets from the 529 plan to a Roth IRA. The transfer is subject to the beneficiary’s annual contribution limit and up to a lifetime maximum of $35,000.
What type of educational expenses can a 529 plan be used for?Â
One of the most attractive benefits of 529 plans is that any withdrawal to pay for a qualified education expense is completely free from federal income tax (and may also be exempt from state income tax).
Qualified education expenses include:
- The full cost of tuition, fees, books, computers and related equipment, and room and board (assuming the student is attending at least part-time) at any college or graduate school in the U.S. or abroad accredited by the U.S. Department of Education.Â
- The cost of certified apprenticeship programs registered with the U.S. Department of Labor.
- Student loan repayments (up to a $10,000 lifetime limit per beneficiary and $10,000 per each of the beneficiary's siblings).
- K-12 tuition expenses up to $10,000 per year.
Many 529 plans require the education expenses to be paid directly to the institution, while others will prepay or reimburse the beneficiary for such expenses. For the most current listing of qualified education expenses, please refer to IRS Publication 970.
What are not considered qualified educational expenses?Â
The most common expenses a student may encounter that aren’t considered qualified expenses under 529 plans are travel (even to and from school) and health care.
How does SECURE Act 2.0 impact 529 plans?
In December 2022, SECURE Act 2.0 was signed into law to enhance retirement savings opportunities for Americans. One provision will allow owners of a 529 plan to move unused funds in the account directly to the plan beneficiary’s Roth IRA.
This option, which will take effect in 2024, may provide beneficiaries with tax-free retirement money. Up until the law is in effect, if beneficiaries use assets in a 529 plan for anything other than qualified educational expenses, the earnings portion of any nonqualified distribution is likely subject to ordinary income taxes and a 10% penalty.
Who can own or contribute to a 529 plan?
Virtually anyone over the age of 18 can open a 529 plan for a student or contribute to an existing one: parents, grandparents, aunts, uncles, siblings and friends. Account owners may qualify for state tax credits or deductions, but should see their tax advisor to determine applicable rules.
How much can I contribute to a 529 plan?
Most states' plans have contribution limits of $400,000 or more to reflect the cost of some of the most expensive colleges and universities in the country. States are likely to continue to raise the limits to keep up with increasing college expenses.
Is there a minimum contribution required to start a 529 plan?
It depends on the plan. Some plans have minimum contribution requirements, but many plan minimums are waived or lowered if you set up your account for automatic payroll deductions or bank-account debits. Like contributions, minimums vary by plan, so be sure to ask your plan administrator.Â
Can I open a 529 plan in anticipation of future (grand)children?
Considering the rising costs of college, it’s smart to plan ahead. But how far ahead can you plan? Although a 529 plan technically needs a named living beneficiary, there is a way to start saving for a child’s education before they’re born.
You can open a 529 plan, name yourself as a beneficiary and start contributing. Once your child or intended beneficiary is born, you can switch the beneficiary to the child before you need to use the education funds. This allows you to start saving for their future education now, while also benefiting from a longer time horizon.
However, there are risks with this approach. For example, if you eventually decide not to have children or your student decides higher education is not right for them, you’ll have to evaluate your options with your 529 account. (Remember, there’s a 10% penalty and tax consequences if 529 plan withdrawals are used for something other than qualified educational expenses.)
It’s also important to know that there will soon be greater flexibility with 529 plan assets. Beginning in 2024, beneficiaries of 529 plans that have been in place for 15 years or more can transfer assets from the 529 plan to a Roth IRA. The transfer is subject to the beneficiary’s annual contribution limit and up to a lifetime maximum of $35,000.
Is it better to put money into a plan as a lump sum or as regular contributions?
The answer to this frequent 529 plan question ultimately depends on your situation. Since a 529 plan allows earnings to grow tax-deferred, the sooner you contribute money, the sooner it can potentially generate earnings.
If the fees charged by your 529 plan account decrease as your contributions rise, investing a large lump sum could potentially reduce the amount you pay in fees over the long term. However, if the lump sum is large, it could potentially have unwanted gift tax consequences.
Periodic investing, on the other hand, lets you easily direct future contributions to other investment options in your plan. Additionally, for many investors, it can be more practical to fund their account with monthly contributions rather than a lump sum.
How do I optimize my 529 plan contributions for tax purposes?
Although 529 plans are tax-advantaged, there's no way to time your contributions to minimize federal taxes. If your state offers an income tax deduction for contributing to its plan, however, consider contributing as much as possible in your high-income years. But there are simple strategies you can use to optimize your contributions.
One such strategy is superfunding also known as forward-gifting. 529 plans don’t have annual contribution limits, but contributions are considered gifts for federal tax purposes. To qualify for the federal gift tax exclusion in 2023, contributions need to be $17,000 a year or less ($34,000 for a married couple giving jointly). However, 529 plans allow you to gift a lump sum of up to five times the amount of the annual gift tax exclusion — $85,000 for individual gifts or $170,000 for joint gifts — and avoid the federal gift tax, provided you make an election on your tax return to spread the gift evenly over five years. This rule, unique to 529 plans, is especially valuable for those looking to remove assets from a taxable estate.
A person who chooses to take full advantage of the five-year spread for 529 plans would not be able to give additional gifts to that person during the five-year period without filing a gift tax return, unless the gift tax exclusion were increased, such as through an inflation adjustment in a subsequent year.
How important is the timing of withdrawals?
If you’re the account owner, you’ll decide when to withdraw funds from your 529 plan and how much to take out. Here are a few considerations on timing withdrawals:
- It’s generally wise to wait as long as possible to make 529 plan withdrawals because the longer the money stays in the account, the more time it has to grow tax-deferred.
- It’s important to coordinate withdrawals with any education tax credits you or your student may qualify for. That’s because you can’t claim a tax credit for tuition that was paid for by using tax-free 529 plan funds.
- If your student is currently in school, understand that distributions from a 529 plan owned by anyone other than the student or the parent for the prior two years are required to be reported as untaxed income on the Free Application for Federal Student Aid (FAFSA) until the 2024-25 school year. As such, if your student has a nonparent 529 plan account, you may want to consider how to time distributions to avoid negatively affecting your student’s financial aid eligibility. (See What’s an effective strategy for gifting a 529 plan? question for more details.)
In collaboration with your tax professional, we’ll help you time your distributions to seek a more optimal advantage.
What’s an effective strategy for gifting a 529 plan?
There are a few common 529 plan gifting strategies to help reduce the impact on financial aid:
- Changing the account owner: For 529 plans not owned by a custodial parent, one strategy is to change the account owner to the parent, though some states’ plans don’t allow this. (The IRS does not specifically address the tax treatment on a change of ownership on a 529 plan. Speak with your tax professional before changing account ownership.)
- Postponing distributions: Another strategy is to delay distributions from a nonparent 529 plan until the student is in the second semester of his or her sophomore year (if graduating in four years). Because the FAFSA looks at income from two years' prior to determine aid eligibility, waiting allows the student to avoid having the distributions affect aid eligibility for their final two years of school.
However, starting in 2022 and going forward (meaning they will have to be reported on the FAFSA for the 2024-25 school year), distributions from a nonparent 529 plan will no longer be reported as untaxed income for the student, which eliminates the need to strategize the timing of those distributions.
What happens if I withdraw money from my 529 plan and don’t use it for eligible college expenses?
If you take money from your account for a nonqualified expense, the earnings portion of the withdrawal is subject to federal income tax — and a 10% federal penalty. It may also be subject to state income tax and penalties.
Will 529 plan contributions and distributions affect need-based financial aid?
Yes, though usually not as much as people assume. It depends on who owns the account and how the money is distributed.
While a 529 plan owned by a parent or a dependent student is counted as an asset under the FAFSA, such plans will only reduce need-based aid by a maximum of 5.64% of the asset’s value. What’s more, qualified distributions from a student- or parent-owned 529 plan don’t count toward the same year’s need-based aid eligibility under the FAFSA.
If you have a 529 plan owned by a grandparent or other nonparents, you should be aware of the following FAFSA rule change:
- In previous years, money distributed to students or spent on their behalf had to be reported as untaxed income, which in some instances significantly impacted the amount of aid a student was eligible for.
- But starting in 2022, money distributed to students or spent on their behalf by nonparents won’t be reported as untaxed income and won’t impact the amount of aid a student will be eligible for.
- (Note that because the FAFSA considers distributions received from anyone other than a parent two years prior to the year of filing as the basis for aid calculations, distributions from 2020 and 2021 will be reported on the FAFSA over the next two years.)
The College Scholarship Service (CSS) Profile, meanwhile, counts all 529 plans that list a student as a beneficiary, regardless of the account owner, in its asset calculations. The CSS Profile also includes a sibling’s 529 plan (at least those under age 19 and not yet in college) when determining expected family contribution.
Does it matter which state’s plan I use?
Each state’s 529 plan has different investment options and fees. Reach out to us if you have any questions about which 529 plan may be a fitting option for you. In addition, your tax professional can evaluate the availability of any state tax credits and deductions.
What are the potential disadvantages of a 529 plan?Â
- You can only make cash contributions to 529 plans – no stocks, bonds or mutual funds. If you have money tied up in such assets and would like to invest that money in a 529 plan, you must liquidate the assets first.
- If you want to change your investment options in your 529 plan, you can generally only do so twice per calendar year for your existing contributions. (However, you can change your investment options at any time for future contributions, or when you change the account’s beneficiary.)
- 529 plan owners interested in making contributions or withdrawals for K-12 educational expenses should understand their state's rules and how those funds will be treated for tax purposes.Â
Create a 529 plan strategy that’s right for you
Reach out to us if you have questions – we’ll help you determine if a 529 plan makes sense for your family and how these savings plans fit with your long-term financial goals.
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