How 529 Plans Work (In Simple Terms)

How 529 Plans Work (In Simple Terms)

529 Plans are tax-advantaged investment accounts designed to help parents (and grandparents and other caring adults) pay for educational expenses.

The plans offer an ideal account for parents who want to save money for a child’s college expenses, but they also work for other educational expenses too!

After years of diligent saving and investing, you can take tax-free distributions money from a 529 account as long as the money is spent on qualified educational expenses. Though the plans have some complications, we’ve broken down how 529 plans work into simple terms.

What Is A 529 Plan?

A 529 plan is a government-sponsored education savings account that offers federal tax benefits. Each state creates and sets up the rules for its’ own plan. Investment growth inside of a 529 plan isn’t taxed as long as the money is used for a qualified educational expense. Most people who invest in 529 plans intend to use the money to help pay for college, but they are growing in popularity for other qualified expenses too.

One unique feature of 529 plans is that each state offers its version of the 529 plan. Technically, you can open a 529 plan in any state (or multiple plans across states too). But before you start comparing features of each plan, you will want to review the tax incentives in your state. You may need to contribute to the 529 plan from your state to qualify for the tax incentives. 

There are two major types of 529 plans. The first is a prepaid tuition plan. Under this plan, you can buy college credits at today’s prices, and your beneficiary can use those credits in the future. Nine states (Florida, Maryland, Michigan, Mississippi, Nevada, Pennsylvania, Texas, and Washington) offer prepaid tuition plans. Prepaid tuition plans allow you to lock in higher education for today’s prices. Unfortunately, these plans tend to offer less flexibility than the second type of 529 plan.

The second type of 529 plan is an education savings account. These plans allow you to open an investment account on behalf of a designated beneficiary (usually your child). Investment options vary from plan to plan. However, most plans allow you to invest in mutual funds or low-cost index funds. 

How A 529 Plan Works

Now that you know what a 529 plan is, how does it work specifically?

First, you open a 529 plan – typically your state’s plan.  

Second, you have an account owner (you – the parent or grandparent), and a beneficiary (the child you’re using the plan for in the future). Note: you can also setup a plan to have yourself be both the plan owner and beneficiary.

Third, you deposit money into the plan – ideally you qualify for some tax incentives for your contributions. See this guide to which states offer tax incentives for 529 plan contributions. 

Fourth, you invest the money over time.

Finally, you withdraw the needed funds for qualified expenses tax-free!

One of the drawbacks of a 529 plan is that if you don’t use the money for a qualified expense, you could face taxes and penalties on the money. Here’s a full guide on how to avoid the 529 plan penalty.

How A 529 Plan Works Infographic

Using 529 Plan Funds For Qualified Expenses

529 plans were originally designed to help parents save and invest for college expenses. But the accounts can now be used to pay for an array of qualified expenses including K-12 private education expenses, apprenticeship programs, student loans and higher education.

Today, qualified expenses can include:

  • Tuition
  • Room and board (including on-campus meal plans)
  • Required technology items
  • Textbooks and other required supplies
  • Up to $10,000 per year of K-12 tuition.
  • Up to $10,000 to repay student loans.

If a designated beneficiary doesn’t use all the funds in their 529 plan for educational expenses, the funds can be transferred to another family member (including the beneficiary’s siblings or the beneficiary’s children).

When that option doesn’t make sense, up to $35,000 can be contributed to the beneficiary’s Roth IRA account.

Important Note On Qualified Expenses

Since each state create’s their own plan and rules, not all states conform to the federal 529 plan rules. For example, many states do NOT allow you to use a 529 plan for K-12 education, student loans, or converting to a Roth IRA. Please check your state’s plan rules first!

Tax Advantages For 529 Plan Contributions

The primary advantage of 529 plan contributions is tax-free growth and income inside the account. Neither the Federal government nor states tax investment income as long as the investments are inside of the account. Additionally, you will not have to pay taxes on the distributions as long as the money is used for a qualified expense. If the money is used for an unqualified purpose, the growth in the account is subject to a 10% penalty.

The Federal government doesn’t offer tax deductions or credits for contributing to a 529 plan. But many states offer tax credits or deductions when a person contributes to a 529 plan. These state tax incentives can make saving for college even more appealing. Contributing enough to claim your state’s tax incentive can put you well on your way towards saving for college for your child.

529 Plan FAQs

What are the contribution limits for a 529 plan?

Contributions to the 529 plan are based on the gift tax limits. In 2023, an individual can contribute up to $17,000 per beneficiary.

A couple can contribute up to $34,000 per individual. However, the $17,000 limit isn’t a “hard cap” on contributions. A person can “super-fund” an account with up to 5 years of contributions at one time. In 2023, the individual super-funding limit is $85,000 per beneficiary.

There are also limits on the total amount of money that can be contributed to a 529 plan per beneficiary. Lifetime contribution limits range from $235,000 to $531,000 depending on the plan being used.

Custodians who are concerned with lifetime contribution limits should carefully review a plan’s limits before signing up for that plan.

Should I use the 529 Plan offered by my state?

Most of the time, states that offer tax deductions or credits require you to open a 529 plan sponsored by your state. In that case, you should open the 529 plan offered by your state.

If you live in a state that offers no tax advantages for contributions (including in states with no State income tax), you can open a 529 plan wherever you want.

For example, you may choose a Nevada 529 plan which is sponsored by Wealthfront or Vanguard.

There are seven states (Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania) that extend their credits to contributions in any 529 plan (not just the plan offered by that state). People living in these states can also choose whichever plan they like the most.

What are the alternatives to 529 Plan accounts?

A 529 plan is an ideal account to help parents save for their child’s college education. However, it’s not the most flexible account available.

When the funds in the account aren’t used for qualified expenses, the account owner will pay taxes on the investment growth. On top of that, you’ll pay a 10% penalty on all the growth in the account.

If you’re looking for a more flexible account for your child, a UGMA or UTMA may make more sense in your case. Parents looking to save for a disabled child may prefer to use an ABLE account which has more qualified expenses and different contribution limits.

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