What is a 529 plan?
These tax-advantaged investment accounts help families save for education expenses
College is expensive. According to recent data from the Education Data Initiative, students are now spending $36,436 per year for college, on average. This makes saving for college all the more important.
529 plans are tax-advantaged college savings accounts that allow parents to save for their children’s college expenses. Each state offers its own plan, including tax incentives, investment choices and fees.
Key insights
- 529 plans are tax-advantaged college savings vehicles used for education expenses.
- 529 plans offer state tax incentives on contributions and are tax-free at the federal level when used for qualifying expenses.
- 529 plans can be used for college, K-12 private school or even student loan payments.
- 529 plans can be converted to a Roth IRA starting in 2024 (restrictions apply).
What is a 529 college savings plan?
“529s are tax-advantaged accounts specifically designed for education purposes,” said Carman Kubanda, a financial planner at Innovative Wealth Building. “They allow for the growth in the account to be withdrawn tax-free if the funds are used for qualified education expenses.”
There are two types of 529 plans:
- A college savings plan allows you to save for college in an account that grows tax-free and lets you withdraw funds for education expenses tax-free as well.
- A prepaid tuition plan lets you pay for college tuition at today’s costs for designated colleges and universities. The funds can be used for tuition only.
529 college savings plans can be used to pay for college expenses, such as tuition, books, class materials, lodging and meal plans. But funds can also be used to pay for private school expenses for kindergarten to 12th grade, certificate programs or even student loans.
529 college savings plans allow you to invest the funds deposited, typically in prebuilt portfolios of exchange-traded funds (ETFs) or mutual funds. The funds grow tax-free and aren’t counted as income when used for qualifying education expenses. There are also state-level tax incentives in many states.
How does a 529 plan work?
529 plans help you save for college by giving state-level tax incentives, as well as avoiding taxes on withdrawals.
529 plans are available at the state level, meaning you can sign up for a 529 plan through a state-sponsored website. For example, the Ohio 529 plan is called “CollegeAdvantage” and can be signed up for through the Ohio Tuition Trust Authority.
College savings plans let you deposit funds into an investment account for education expenses. The funds can be invested in portfolios created by the plan administrator. This helps your money grow over time to help pay for the ever-increasing costs of college.
You can withdraw funds to pay for expenses as they come up, including tuition, fees, room and board and other college expenses. The 529 plan custodian will distribute a 1099-Q to use in your tax return showing the fund distributions, and the amount used for qualifying educational expenses (as well as unqualified expenses).
» MORE: What is a good investment?
529 contribution limits
Unlike retirement plans, 529 plans don’t have annual contribution limits, but rather limits to the total contribution of the plan. Each state caps contributions to 529 plans individually, and the limits range from $235,000 up to $550,000.
Contributions to 529 plans are considered gifts to your child and are subject to gift tax limitations. If you deposit more than $17,000 per child per parent, it will count against your lifetime gift tax exclusion. But the exclusion is over $12 million at this point, so you won’t hit that threshold with 529 deposits alone.
529 plans also let you deposit up to five years’ worth of gifts to use over a five-year period. So you can deposit $17,000 x 5 = $85,000 without it counting against your lifetime gift tax exclusion.
Roth IRA conversion (starts in 2024)
If you don’t end up using all the 529 funds in the account, you will now have the option of converting those funds to a Roth IRA for your child. The SECURE 2.0 Act (passed in 2022) allows Roth IRA conversions of up to $35,000 of unused 529 funds.
There are some requirements, including:
- The 529 plan must be open in the designated beneficiary’s name for at least 15 years. Transfers will reset this clock.
- You cannot convert more than the annual Roth IRA limit per year (currently $6,500, or $7,500 if aged 50 or older).
- You can’t convert more than you contributed to the 529 account before the five-year period ending on the date of the distribution.
This can be a great option for parents who are worried about 529 funds being stuck if they don’t end up using them all.
529 tax benefits
529 plans offer several tax benefits, including state tax savings and credits, as well as tax-free withdrawals when used for eligible education expenses.
Indiana, Oregon, Utah and Vermont offer state tax credits for 529 plan contributions. There are 25 other states that offer a state tax deduction amount (varies by state).
There are several states with no tax benefits on contributions at all, including some states that assess a state income tax.
In addition to state tax benefits, 529 plans grow tax-free. That means as you invest in the account, growth and dividends are not taxed while the account is growing, similar to an IRA account. And when you withdraw funds for qualified education expenses, there is no income tax assessed on those withdrawals.
This tax savings can mean paying much less in taxes versus using a regular brokerage account. For example, if you’re in the 22% tax bracket, selling investments in a brokerage account might be charged 22% for short-term capital gains, or between 0% to 20% for long-term capital gains taxes. 529 accounts will charge 0% on all withdrawals for qualified education expenses, regardless of your income.
» MORE: Capital gains vs. investment income: how they differ
What can 529 funds be used for?
529 plans allow you to use the funds for most education-related expenses for the plan’s beneficiary. This includes tuition, books, class materials, lodging (for college) and meal plans offered by the school.
Note that if you don’t use all your 529 plan funds, you can switch beneficiaries. This lets you use the remaining funds for another child or even another family member.
You can use any 529 plan to pay for education expenses in any state. The beneficiary doesn’t have to attend school in the same place as the 529 plan. This includes both college savings plans and prepaid tuition plans.
529 qualified expenses
Here’s a list of 529 qualified expenses:
- College tuition and fees
- Vocational and trade school tuition and fees
- Elementary or secondary school tuition
- Student loan repayment
- Off-campus housing
- Food and meal plans
- Computers (and related software)
- Internet
- Special needs equipment
- IRA rollover (starting in 2024)
» MORE: Student loans vs. personal loans
How to open a 529 plan
To open a 529 plan, you can find your state-sponsored plan options and choose one that fits your needs. All states offer a college savings plan, while only a few still offer prepaid tuition plans.
While there may be specific state tax incentives to sign up for your state’s 529 plan, you can actually pick a plan from any state. Not all 529 plans are created equal, and some offer more flexibility than others, so research to see which ones offer the best investment options, lower fees and most flexibility. If you’re unsure, you can also seek advice from a financial advisor.
Here’s how to sign up for a 529 plan:
- Find a state plan that you like.
- Sign up for an online account, either directly with the state plan or through a broker.
- Input your information, as well as the beneficiary’s information.
- Choose your investments (typically a prebuilt portfolio).
- Fund the account (within state contribution limits).
You can then monitor the account online and track your progress. Again, different states will have different platforms that allow you to see your plan details.
FAQ
Who maintains control over the 529 plan?
The person who set up the 529 plan maintains control of it. Unlike a custodial account, the 529 plan funds never transfer to your child, so you can maintain full control. You can also change beneficiaries at any time.
Are 529 contributions tax deductible?
529 contributions may be deductible at the state level, but they are not deductible against your federal income taxes. Not all states offer tax deductions for 529 plan contributions.
What happens to a 529 plan if your child doesn’t go to college?
If your child doesn’t go to college, 529 funds can still be used for other things, such as vocational or trade schools. And if you have younger children, you can use 529 funds to pay for private school as well. Finally, starting in 2024, if you don’t use the 529 funds, you can convert up to $35,000 of them into a Roth IRA for your child (terms apply).
Which state has the best 529 plan?
The best 529 plan is the one that offers the best state tax credits or deductions. Even if some states offer better investment options or performance, the tax savings is the most important factor when choosing a 529 plan. If you aren’t eligible for state tax deductions (or live in a state with state income tax), then you can review the performance of state 529 plans here.
Bottom line
529 plans offer a tax-advantaged way to save for college while allowing the account to grow through investments. If you have a child who will be attending college, funding a 529 plan can help them avoid student loans and give them a leg up financially.
But 529 plans do have restrictions, so it’s important to understand what they can be used for (and what they can’t) before signing up for one.
Article sources
- Education Data Initiative, “ Average Cost of College & Tuition .” Accessed Sept. 28, 2023.
- College Advantage, “ Ohio 529 Mutual Fund Based Plans .” Accessed Sept. 28, 2023.
- Education Data Initiative, “ 529 Contribution Limits by State .” Accessed Sept. 28, 2023.
- IRS, “ What's New - Estate and Gift Tax .” Accessed Sept. 28, 2023.
- Senate.gov, “ SECURE 2.0 Act of 2022 .” Accessed Sept. 28, 2023.
- IRS, “ Retirement Topics - IRA Contribution LImits .” Accessed Oct. 7, 2023.
- Education Data Initiative, “ 529 Tax Deductions by State .” Accessed Sept. 28, 2023.
- IRS, “ Topic No. 409, Capital Gains and Losses .” Accessed Sept. 28, 2023.
- Saving for College, “ 529 Plan Rankings Q2 2023 .” Accessed Sept. 28, 2023.
