Saving for your kids' college education? Everything you need to know about 529 plans

Canva While it can be amusing to ask children what they want to be when they grow up, funding their future education is no laughing matter. With college tuition costs rising by roughly 6% each year, it’s never too early to start saving. Although many options exist to help you cover your children’s education expenses, one of the most powerful tools is a 529 college savings plan. Wealth Enhancement Group breaks down everything you need to know about 529 plans, from their various types, tax benefits, and expenditures they cover, to their contribution and withdrawal limits, impact on financial aid, and more. What is a 529 College Savings Plan? A 529 college savings plan is a tax-advantaged investment account designed to help families save for future education costs. Named after Section 529 of the Internal Revenue Code (IRC), these plans can be used to cover a range of qualified expenses at over 6,000 eligible colleges and universities across the United States–as well as at hundreds of international institutions. As state-sponsored accounts, 529 plans are also available in virtually every state, although their rules vary from location to location. This makes it important to understand which state’s plan may be right for you. What are the different types of 529 Plans? There are two main types of 529 plans: prepaid tuition plans and education savings plans. Prepaid tuition plans allow you to prepay a portion of future tuition costs at today’s rates to minimize the effect of inflation. They do, however, have some restrictions. First, thanks to state sponsorships, most of these plans require either the account holder or beneficiary to be an in-state resident. Second, prepaid tuition plans generally cover only college and university tuition–not room and board or K-12 educational expenses. Education savings plans, on the other hand, work more like a Roth IRA or Roth 401(k) in that they allow you to invest after-tax dollars into a range of investments, such as mutual funds, exchange-traded funds (ETFs), and bank deposit accounts. Some also offer static fund portfolios and age-based (or target-date) portfolios that adjust the investment mix based on the beneficiary’s age. Deciding which plan is right for you will consequently depend on the available investment options, your risk tolerance, and the length of time you have to invest. What are the tax advantages of 529 College Savings Plans? One of the most attractive features of 529 plans is their tax benefits. Earnings in these accounts grow tax-free, allowing the value of your investments to rise over time. Withdrawals for qualified education expenses are also tax-free, but those withdrawals are limited to $10,000 per year for K-12 expenses. Additionally, some states offer tax deductions or credits for contributions made to their 529 plans, although those tax breaks are generally only available to state residents. What educational expenses do 529 Plans cover? The specific benefits of 529 plans vary by state. You can choose from various state plans, but you will want to check with your advisor to ensure you understand the details. Qualified educational expenses include: Tuition and fees for college, university, apprenticeship programs, or other eligible post-secondary institutions, both in the U.S. and internationally In some states, tuition and fees for students K-12, up to $10,000 per year per beneficiary Room and board for both on-campus and off-campus housing Books, school supplies, computers, internet access, and necessary software Campus food and meal plans Accessibility of equipment for special needs students Student loan repayments to a lifetime maximum of $10,000 per student What are the contribution and withdrawal limits? Unlike some other tax-advantaged accounts like IRAs, 529 plans have no federal annual contribution limit. Instead, each state sets its own contribution limits, which range between approximately $235,000 and $530,000. Despite this flexibility, contributions that exceed the annual gift tax exclusion may have tax implications. For 2023, that amount is $17,000 per year per beneficiary to a 529 plan. However, you can “superfund” a 529 account, which means you’re allowed to make five years’ worth of gifts in a single year. So, instead of gifting up to the exclusion amount of $17,000, you can actually gift five times that much, or $85,000. As mentioned, withdrawals must be used for qualified education expenses to avoid taxes and penalties. Additionally, those withdrawals need to be made in the same calendar year as the expense. That means you cannot withdraw money in December of one year to pay tuition for January of the following year. Although you’re allowed to withdraw money for non-qualified expenses whenever you choose, those withdrawals will be subject to a 10% federal penalty tax, as well as to any state income taxes that apply to early investment withdrawals. That said, certain exceptions exist. For instance, there is no penalty to withdraw money equal to the amount of a scholarship received or equal to the amount of educational assistance provided to the beneficiary from an employer or as a veteran. Those withdrawals will simply be considered regular income and taxed accordingly. Additionally, penalties are waived for beneficiaries who attend a U.S. military academy. Do 529 Plans impact financial aid eligibility? Many parents worry about how 529 plans may affect their child’s eligibility for financial aid. While these plans can impact aid calculations, the effect is relatively minor compared to other assets. That’s because these plans are considered parental assets on the Free Application for Federal Student Aid (FAFSA), which generally has a lower impact on aid calculations than student assets. At a high level, here’s how it works: the first $10,000 saved in a 529 plan isn’t considered at all as part of the Expected Family Contribution (EFC) calculation. For amounts above $10,000, a maximum of 5.64% of the assets will be included in the FAFSA calculation. Plus, when money is withdrawn from a 529 for qualified expenses, those amounts are not brought into a student’s income for financial aid purposes. Until recently, this was only true for parent-owned accounts. As of 2024-2025, however, distributions made from accounts owned by grandparents or other family members will no longer be reported as student income and will not be included as part of the financial aid eligibility calculation. What fees and expenses are associated with 529 Plans? Like any investment, 529 college savings plans come with fees and expenses. For instance, prepaid tuition plans often charge an application fee alongside ongoing administrative expenses. Education savings plans generally charge fees for enrollment, annual account maintenance, and program and asset management. Plus, underlying fund expenses could include charges such as sales loads or distribution fees. Because fees can reduce your total investment returns, it’s important to compare the costs associated with the various state plans you’re considering. Keep in mind, too, that some states help defray those costs by offering tax benefits or even providing matching contributions. So, making an informed choice may require a bit of research. What happens to money left over in a 529 account? There are several reasons why you might have money left over in your 529 college savings plan. For instance, your beneficiary may decide not to attend college or any other eligible educational program. They may receive a scholarship that covers their educational costs. Or, perhaps you simply did a great job at saving and don’t need all the funds in your account. No matter the reason, you won’t want to lose access to those funds, so it’s important to understand the transferability rules associated with 529 plans. While you can always withdraw the money outright, any withdrawals for non-qualified expenses will attract a penalty and be subject to tax. To avoid these costs, you can: Transfer the plan to another family member, such as a child, sibling, parent, or first cousin–or even use the funds for your own education Use the funds to repay up to $10,000 in student loans for the beneficiary and the beneficiary’s siblings (this is a lifetime amount, not an annual amount) Roll over up to $35,000 into a Roth IRA that’s been open for at least 15 years–although this option will only become available as of January 2024 What are the pros and cons of 529 plans? Like any financial decision, 529 plans have both pros and cons. The benefits of a 529 college savings plan include: Tax advantages–such as tax-deferred growth, tax-free withdrawals, and tax-deductible contributions–can provide substantial savings over time Flexibility in using the funds for various education-related expenses High contribution limits and a wide range of investment options tailored to your risk tolerance The ability to open an account in the state of your choice, along with potential incentives for residents of some states Some disadvantages may include: Limited investment options compared to traditional brokerage accounts Penalties for non-qualified withdrawals Restrictions on changing plans or switching investments This story was produced by Wealth Enhancement Group and reviewed and distributed by Stacker Media.