529 Plan

What Is a 529 Plan?

Savings plans grow tax-deferred, and withdrawals are tax-free if they're used for qualified education expenses. Prepaid tuition plans allow the account owner to pay in advance for tuition at designated colleges and universities, locking in the cost at today's rates. 529 plans are also referred to as qualified tuition programs and Section 529 plans.

Understanding 529 Plans

Although 529 plans take their name from Section 529 of the federal tax code, the plans themselves are administered by the 50 states and the District of Columbia. Anyone can open a 529 account, but they are typically established by parents or grandparents on behalf of a child or grandchild, who is the account's beneficiary. In some states, the person who funds the account may be eligible for a state tax deduction for their contributions.

The money in the account grows on a tax-deferred basis until it is withdrawn. As long as the money is used for qualified education expenses, as defined by the IRS, those withdrawals aren't subject to either state or federal taxes. In the case of K-12 students, tax-free withdrawals are limited to $10,000 per year.

There are no limits on how much you can contribute to a 529 account each year, but many states put a cap on how much you can contribute to it in total. Those limits recently ranged from $235,000 to over $525,000.

Types of 529 Plans

The two main types of 529 plans — college savings plans and prepaid tuition plans — have some significant differences.

Savings Plans

Savings plans are the more common type. The account holder contributes money to the plan, which is typically invested in a selection of mutual funds. Account-holders can choose the funds they want to invest in, and how those funds perform will determine how the account grows (or, worst-case scenario, shrinks) over time. Many 529 plans also offer target-date funds, which adjust their holdings as the years go by, becoming more conservative as the beneficiary gets closer to college age.

Withdrawals from a 529 savings plan can be used for both college and K-12 expenses. In the case of a 529 savings plan, qualified expenses include tuition, fees, room and board, and related costs.

Prepaid Tuition Plans

Prepaid tuition plans are offered by a limited number of states and some higher education institutions. They vary in their specifics, but the general principle is that they allow you to lock in tuition at current rates for a student who may not be attending college for years to come. (Prepaid plans are not available for K-12 education.)

As with 529 savings plans, prepaid tuition plans grow in value over time, and the money that eventually comes out of the account to pay tuition is not taxable. Unlike savings plans, prepaid tuition plans do not cover room and board.

Prepaid tuition plans may have other restrictions, such as which particular colleges they may be used for. The money in a savings plan, by contrast, can be used at just about any eligible institution.

You aren't restricted to investing in your own state's 529 plan, but doing so may get you a tax break, so check out that plan first.

Tax Advantages of 529 Plans

The earnings in a 529 plan are exempt from federal and state income taxes, provided the money is used for qualified educational expenses. Any other withdrawals are subject to taxes plus a 10% penalty, with exceptions for certain circumstances, such as death or disability.

The money you contribute to a 529 plan isn't tax-deductible for federal income tax purposes. However, more than 30 states provide tax deductions or credits of varying amounts for contributions to a 529 plan. In general, you'll need to invest in your home state's plan if you want a state tax deduction or credit. If you're willing to forgo a tax break, some states will allow you to invest in their plans as a nonresident.

529 plans have very specific transferability rules, governed by the federal tax code (Section 529). The owner (typically you) may transfer to another 529 plan once per year unless a beneficiary change is involved. You are not required to change plans to change beneficiaries. You may transfer the plan to another family member, defined as:

Other Considerations

As with other kinds of investing, the earlier you get started, the better. With a 529 savings plan, your money will have more time to grow and compound. With a prepaid tuition plan, you'll most likely be able to lock in a lower tuition rate, since many schools raise their prices every year.

If you have money left over in a 529 plan — say the beneficiary gets a substantial scholarship or decides not to go to college at all — you'll have several options. One is to change the beneficiary on the account to another relative, as financial advisor Jay Murray describes in the box above. Another is to keep the current beneficiary in case they change their mind about attending college or later go on to graduate school. If worse comes to worst, you can always cash in the account and pay the taxes and 10% penalty.