What Is a 529 Plan? How It Works

There are two types of 529 plans: education saving plans and prepaid tuition plans.

1. Education saving plans

In general, you can use education savings plans at any college or university to pay for tuition at elementary or secondary schools.¹ These savings plans also cover qualified education expenses, like tuition, mandatory fees, and room and board.

When setting up an education savings plan, the saver can typically choose from a range of investment options, including mutual funds and exchange-traded funds (ETFs).

Some plans offer static fund portfolios; others offer age-based portfolios, also called target-date portfolios. With target date portfolios, the investments tend to get more conservative as the beneficiary approaches college age.

Education savings plans are administered by state and currently offered in 49 states and Washington, D.C..² Due to the plan’s flexibility, it’s the more popular option.

2. Prepaid tuition plans

Pre-paid plans are administered by individual states and higher education institutions. With a prepaid tuition plan, you can pre-purchase college tuition for the future at today’s rates.

You can decide if you want to buy between one and four years of tuition. When the child is ready to go to school, the plan pays out based on tuition rates at that time.

The plan is less flexible than the savings plan, as it only covers tuition and mandatory expenses—excluding room and board. Also, you can’t use it to prepay elementary or secondary school tuition.

Many prepaid plans have residency requirements for the saver and beneficiary.¹ While some states guarantee the money paid into the prepaid plan, some don’t. This means you could lose some or all of your money if the plan’s sponsor has a financial shortfall.

If the beneficiary doesn’t attend a participating college or university, they might receive less money than if they attended a participating school.

The 529 plan offers some important tax advantages at the federal and state level. The specific benefits of 529 plans vary between states and the specific plan.

Before investing, make sure you understand the tax implications associated with each plan. If you have questions, reach out to a tax professional.

Federal tax benefits

One major benefit of a 529 is that earnings grow tax-free. If the beneficiary withdraws money to pay for a qualified education expense, the earnings are not subject to federal income tax and, sometimes, state taxes.

Withdrawals that aren’t used for qualified education costs are subject to state and federal taxes and a 10% federal tax penalty on earnings.¹

State tax benefits

In many cases, you’re only eligible for state benefits if you invest in a state-sponsored 520 plan. Benefits can include deducting contributions from state income tax or providing matching grants.

If you know you want to open a 529 plan for your child or grandchild, but you’re still not clear on how to do it, follow these steps:

1. Choosing a 529 plan

Start by researching your state’s 529 plan, though this doesn’t mean you have to invest. You can check out other plans to find one (or more) that offers investment options, a time horizon, and a level of risk you’re comfortable with.

When researching plans, compare factors like quality, cost, fees, minimum contribution amounts, and state tax incentives. The College Savings Plans Network’s plan search tool makes it easy to compare 529’s.

2. Opening an account and designating a beneficiary

Once you select a plan, it’s time to open the 529 account. You can open a direct-sold savings plan or an advisor-sold plan.

• Direct sold. Purchase from the plan manager, making you responsible for selecting and managing your investments through the plan’s online account portal.³
• Advisor sold. Purchase from a financial advisor who will manage the plan’s investments for a fee.

You’ll need to provide some personal information, like your name, address, social security number (SSN), and the beneficiary’s name.

The beneficiary (your child or grandchild) will receive the 529 funds when qualifying school expenses need to be paid.

It’s possible to change the beneficiary to another family member, and there are no tax consequences.

3. Contributing to 529 plans

Once you’ve opened your 529 account, you can start contributing. Contributions can’t exceed the amount necessary to cover qualified education expenses for the beneficiary and can vary between plans.

For example, in New York, the maximum contribution is $520,000. In Mississippi, the maximum contribution is $400,000.⁴

Use the College Savings Plan Network’s search tool to determine the maximum contribution for your state.

4. Choosing a 529 plan investment portfolio

Choices will vary between plans, but some common options include age-based or static investments.

• Age-based. Asset allocation will adjust based on the beneficiary’s age. Generally, these investments start with a more aggressive strategy and become more conservative over time.
• Static. You choose a risk tolerance level for your portfolio, which remains constant over time.

5. Withdrawing funds from 529 plans to pay for qualified expenses

What can 529 funds be used for? Being clear on the difference between qualified and unqualified expenses can help you avoid paying taxes on withdrawals.

Here are some examples of qualified and unqualified expenses.

Next, consider when you want to withdraw money from your 529 account and use it for qualified expenses. Remember, you can use it to pay for elementary, secondary, or post-secondary education.

Figure out how much you want to withdraw and submit a withdrawal request online. Make sure you withdraw and spend the money within the same calendar year—which isn’t the same as a school year.

Lastly, in case you’re ever audited, it’s a good idea to keep all of your receipts.

Before you invest in a 529 plan, consider the benefits and drawbacks.

Pros of 529 plans

• Flexible plan location. You are not restricted to the 529 plans offered in your state. You are free to look to other states to find the plan that’s best for you and your family.
• Tax-deferred growth. Any earnings in a 529 plan are not subject to taxes while in the account.
• Tax-free withdrawals. Withdrawals for qualified education expenses are typically not subject to federal or state income tax.
• Tax-deductible contributions. Many states deduct 529 plan contributions from state income tax.
• Transferable. It’s easy to transfer the money in a 529 from one child to another.
• Roll into a Roth IRA. Unused money in a 529 account can roll over into a Roth IRA account for the same beneficiary.⁵
• Pay off student loans. It’s possible to use up to $10,000 to pay off the student beneficiaries’ student loans.

Cons of 529 plans

• Limited investment options. Education savings plans have pre-set investment options and you can’t switch freely between them.
• Fees can vary. Factors such as choosing a savings or pre-paid plan, advisor-sold or direct-sold plan, and state offering the plan can impact fees.
• Impact financial aid. Investing in a 529 plan can impact a student’s eligibility to receive need-based college aid.⁶ However, the more money you save, the less money you have to borrow.
• Restriction on switching investments. Account holders can change options twice per year or if there’s a beneficiary change.⁷
• Must be used for education. The money withdrawn from a 529 account can only be used for qualified education costs.
• Withdrawal restrictions. With few exceptions, you’ll have to pay taxes and penalties on withdrawals that aren’t used for qualified education expenses.¹

A 529 plan is a tax-advantaged plan that aims to make it easier for families to save for college. The sooner you start saving, the longer your investments have to grow.

Before opening a 529, give yourself time to research and compare multiple plans to see which one is the right fit.

For tips on how to manage your finances while attending college, check out our college finance guide.