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

Michael Lux Paying for School, Student Loan Blog 9 Comments

In the United States, the average annual household income is around $65,000. Meanwhile, the average cost of college in the U.S. is approximately $35,000 per student per year. The growing cost of tuition can place an overwhelming hardship on families wishing to send their children to college. However, planning ahead can substantially ease the burden. A 529 plan is a valuable tool for many families.

A Quick Lesson
A 529 plan is a savings plan, similar to a retirement account. It gets its name from the tax code section that created it. States (or sometimes eligible educational institutions) establish and maintain these plans. Such plans allow the account holder to either prepay a child’s school expenses or contribute to an account that will pay for those expenses when the time comes. 

How a 529 Plan Works

Simply put, a 529 plan is a tool to shift money from the government to your child’s education. Typically, the government would tax money that your child’s college fund earns (i.e., the interest or investment growth). However, the money earned in a 529 plan isn’t taxable. Though this may seem like a minor benefit, over the course of a decade or two, this can generate thousands of additional dollars.

As an added bonus, many states offer tax deductions or credits for contributions made to a 529 plan. Please note, however, that some states may limit the amount that qualifies for the deductions or credits.

Please check out this guest post to learn how a recent law change could help you benefit even more from 529 plans.

Types of 529 Plans

There are two main types of 529 plans.

Prepaid Tuition Plan

A prepaid tuition plan lets you purchase credits at participating colleges and universities (usually in-state and public ones). The beneficiary can use the credits towards future tuition and mandatory fees, but you pay for them at current prices. If you’ve watched the price of college increase over the past 30 years, you can guess how advantageous this plan could be. By locking in tuition costs at current market levels, you could potentially save thousands of dollars.

There are some details to consider, though. For example, not all states offer prepaid tuition plans. Of those that offer them, most have residency rules. Additionally, the federal government doesn’t guarantee prepaid tuition plans – nor do some of the state governments. This means that there is a risk that you lose some or all of the money you paid into the plan. Also, if the beneficiary doesn’t wind up attending one of the participating schools, the payout from the plan may be much less than you had hoped for.

Education Savings Plan

Education savings plans are the more commonly used version of the 529 plans. An education savings plan is an investment account used to save for the beneficiary’s tuition, mandatory fees, and room and board. All states offer these kinds of plans, and most states don’t have residency rules for them. However, neither the state nor the federal government will guarantee most investments in these plans.

These plans offer the most flexibility to you and the beneficiary. For example, many brokers offer college savings plans according to your particular needs. If Junior (who is many years away from college) is the beneficiary of a 529 plan, you can direct that the plans’ funds be invested aggressively. Once Junior enters high school age, you can shift the fund towards a more conservative investment strategy. When Junior is ready for college, he can select from most U.S. (and some non-U.S.) schools.

Who Gets the Money?

When you create a 529 plan, 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. Whoever you name as the beneficiary will receive distributions for qualified educational expenses.

Changing beneficiaries is easy. The IRS doesn’t assess a penalty if you change the beneficiary to a qualifying member of the beneficiary’s family. Additionally, if you want to rollover (or transfer) assets from a 529 plan, you can do this tax free. It is generally tax free if you roll it over into another 529 account or an ABLE account (a plan for those with disabilities) for the beneficiary or the beneficiary’s qualifying family member.

Please be aware that there is a possibility that the assets in a 529 plan can affect a student’s financial aid eligibility.

Taking Money Out of the 529

All 529 plans allow you to make withdrawals for qualified tuition and mandatory fee payments. Education savings plans allow you to also make withdrawals for room and board, as well as other qualified education expenses (such as a new computer for school).

However, should you fall on hard times and need to withdraw the funds for an alternate purpose, the cost can be high. You will have to pay taxes on any earnings you withdraw. The IRS also tacks on an additional 10% penalty. Therefore, you should avoid non-educational withdrawals from the 529 plan unless it is absolutely necessary.

What questions should I be asking?

If you are contemplating 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 does the plan offer?
  • 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 to allocate such a large quantity of money towards something that may not be necessary. Many kids don’t end up attending 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 costly.  Starting a 529 plan 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, the probability that you can utilize your 529 plan is particularly high.

Choosing to create a 529 plan early not only offers tax advantages, but it also helps develop good savings habits. It 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:
The Wall Street Journal on how to pick a 529 (subscription required)
The Wikipedia entry on 529 Plans
IRS Q and A on 529 Plans

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

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Holly@ClubThrifty

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.

Matt Becker

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.

Grayson @ Debt Roundup

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.

Andrew@LivingRichCheaply

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.

Monica @MonicaOnMoney

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