529 Plan Basics: An Easy to Understand Guide to College Planning

Michael Lux Blog 9 Comments

Planning for your child’s future is an important and noble goal.  With college prices on the rise and national student debt levels in excess of a trillion dollars, planning ahead has never been more critical.  Putting money into a 529 can help you achieve this goal.

How a 529 Plan Works

At its most basic level a 529 is a tool to shift money from the government to your child’s education.  Instead of being taxed on the money that you earn with your child’s college fund, that money can be directly applied to educational costs.  Though this may seem like a minor benefit, over the course of a decade or two, this can generate thousands of additional dollars for school.

529 savings

This chart shows how much extra money can be earned via a 529 savings plan. Image courtesy of

Not only are you able to avoid paying taxes on the money earned by your 529, but many states offer a tax deduction for contributions made to a 529 plan.

Types of 529 Plans

There are two main types of 529 plans.  The first type, offered only in some states, is called a prepaid tuition plan.  With a prepaid tuition plan, you are able to lock in tuition rates at current market levels.  If you have watched the price of college increase over the last 30 years, you have seen how big of an advantage this can be.  Think of this plan as working like a defined benefits pension.  Another advantage of these plans is that they are guaranteed or backed by the state.  You will not run the risk of losing money due to market conditions.  If you are interested in a prepaid tuition plan make sure to investigate your states residency requirements and enrollment period.

The second type of 529 plan is a college savings plan.  If the prepaid tuition plan was like the defined benefits pension, the college savings plan works like a 401(k).  These plans offer the most flexibility and have year round enrollment periods.  Many brokers also offer college savings plans according to your particular needs.  For 529s with beneficiaries many years away from college, the funds will be invested in a more aggressive manner.  Once junior gets into high school, the fund shifts towards a more conservative investment strategy.  These plans are offered in all states and there are no residency requirements.

Who Gets the Money?

When you create a 529 you will name a beneficiary.  In most instances this will be your child.  However, there is no requirement that it be a child or even a family member.  In fact, changing beneficiaries is very easy, and there is no penalty accessed.  Additionally, if you have multiple 529s for multiple children, there is no penalty for transferring between accounts (the only way you would incur any fee would be if you transferred enough money to run into gift tax issues – for single people that is $65,000, for married couples it is $130,000).  Thus, whether you have two kids or a dozen grandchildren, you can adjust your 529s to make sure that the needs of all your beneficiaries are met.

Taking Money Out of the 529

Most 529 plans allow for money to be withdrawn for all educational purposes, for everything from the cost of tuition, to a new computer for school.  (Note: the exception here is that the prepaid tuition plans in some states apply only to tuition and mandatory fees.)  However, should you fall on hard times and need to withdraw the funds for an alternative purpose, there will be high costs.  First, you will have to pay all of the regular taxes that you avoided by using the 529.  Second, there is a 10% penalty accessed on top of the regular taxes.  Therefore, you should avoid non-educational withdrawals from the 529 unless it is absolutely necessary.

What questions should I be asking?

If you are considering a 529 plan, the SEC has put together a great list of questions to consider.  Among the most important:

  • Is the plan available directly from the state or plan sponsor?
  • What fees are charged by the plan and what goes to my broker?
  • What are the plan’s withdrawal restrictions?
  • Which colleges and universities participate in the plan?
  • What if my beneficiary does not need the 529 funds for college?
  • What types of investment options are offered by the plan?
  • Does my state’s plan offer tax advantages or other benefits for investment in the plan it sponsors?
  • How has the plan performed in the past?

Is a 529 right for me?

If you are sitting at home with a toddler or even just staring at your first ultrasound, college can seem like a very distant concern.  Given all the uncertainties of life, you may be fearful allocating such a large quantity of money towards something that may not be necessary.  Many kids don’t end up going to college and many others get scholarships covering all of their expenses.  However, for the vast majority of Americans, college is a part of life and it is very expensive.  Starting a 529 now could generate thousands of extra dollars for school and prevent your child from becoming a student loan horror story.  If you have multiple kids, due to the ease of adjusting beneficiaries and transferring funds, the probability that your 529 will be utilized is especially high.

Choosing to create 529 plan early not only will offer many tax advantages, but it also creates the good monthly habit of putting money away for college, and encourages people not to touch those funds for any other reason.  These advantages and incentives can help you on your way to maximizing the college opportunities for your child or children.

Further Reading:
IRS Q and A on 529 Plans
SEC Introduction to 529 Plans
The Wall Street Journal on how to pick a 529
The Wikipedia entry on 529 Plans

Have you started a 529 or been the beneficiary of a 529?  How did it affect your college experience?


  • I started a 529 for each of my kids when they were babies and I am sooooooooo glad that I did. They are 2 and 4 now and they have started to really accumulate some cash in those accounts. I contribute to each of them monthly and I also put all of their Christmas/birthday money in there.

    • That is awesome! Starting the 529 early is definitely the way to go.

  • Nice overview. We started a 529 for our son and contribute a small amount each month to it. We also put gift money he gets into it. Our current contribution level certainly won’t fund 4 years of college, but it’s nice to have something.

    One additional point, I believe you are allowed to withdraw money penalty-free if your child gets scholarships. I’m honestly not clear on all of the rules surrounding that, but it can eliminate some concerns about the money being wasted.

    • It is a great thing to do for your child. As one who recently graduated, I know without a doubt that every little bit helps.

      Your scholarship exception sounds very interesting. I will check to see when and how it applies and update the post accordingly. Thanks for the heads up!

  • I started a 529 three days after my son was born. We get tax advantages in our state, but if I had to take the money out, I am only taxed on the earnings since I am contributing after tax money. I still have the penalty, but it works the same was as a Roth IRA with regards to taxing the earnings, not the contributions.

    • Wow! You didn’t waste any time setting that up. It sounds like your state has a great program for you and your son.

  • My son was born about a week ago, but I started a 529 plan a few months ago. There was a LivingSocial deal which gave me $75 for $25. So there is $75 in the plan. I will start contributing a little bit each month. My state also has a tax deduction for the plan.

    • Congrats on the birth of your son! And great find on the 529… that $50 head start sounds awesome!

  • Thanks for explaining the 529 in detail! This is very informative for readers.