How do 529 plans work?
A 529 education savings plan is a tax-favored program operated by a state designed to help families save for future education costs.
529 education saving plans, legally known as qualified tuition plans, can help parents and grandparents save for a child’s future education. Since after-tax funds are used for the account, the account grows tax-deferred, and withdrawals are tax-free when used for education.
Each state has at least one 529 college fund available, and they are designed to have tax advantages. When you purchase a state 529 plan, each account will have a beneficiary and an owner who controls how the funds are invested. There are two types of 529 plans — Education Saving Plans and Prepaid Tuition Plans — and each are designed differently. Having a 529 plan does not guarantee acceptance to any educational institution.
Types of 529 plans
Read on for information about the two types of 529 plans.
Education Savings Plan
Between the two types of savings plans, an Education Savings Plan is the most common. Money is invested into the plan (much like a 401k) and the investor selects the type of investment — typically a mutual fund, Exchange-traded fund (ETF) or principal-protected bank product. The investor may switch the investment as they deem necessary based on fluctuations that may occur over time. An investor can also choose to use a target date fund which typically starts out with higher growth potential and gradually becomes more conservative as the target date of use is closer. Starting a fund early allows it to grow and accumulate over many years.
With an Education Savings Plan, the funds can be used at almost any eligible institution and can typically be used for tuition, fees, books, equipment, room and board. In certain states, students with Education Savings Plans can also use up to $10,000 annually for kindergarten through high school.
Fees may be assessed for enrollment, account maintenance fees, program management and asset management.
Prepaid Tuition Plan
Prepaid Tuition Plans allow the investor to purchase future tuition at today’s price by purchasing units or credits. Prepaid plans are typically used within the same state you purchased the plan. Prepaid Tuition Plans do not pay for kindergarten through high school and typically only pay for college tuition and fees — not equipment, room or board.
Plans vary from state to state, and some states guarantee the money paid into the plan, other states do not. With a Prepaid Tuition Plan, fees may apply for the enrollment and administration.
Tax benefits of state 529 plans
In addition to being tax-deferred and payments being tax-free, many states offer state income tax deductions and tax credit when funds are used for a state 529 plan.
What if there is money left in the 529 account?
When money is left in a student’s account, there could be a few options:
- Keep the money in the account in case the child decides to further their education.
- Transfer the amount left into the 529 account of another eligible family member.
- Use up to $10,000 to pay off private or federal student loans.
- Roll over up to a lifetime limit of $35,000 into a Roth IRA beginning January 1, 2024.
- The Roth IRA must be in the name of the beneficiary.
- The 529 account would need to be owned a minimum of 15 years.
- 529 contributions made in the last 5 years are ineligible for rollover.
- The rollover amount is subject to and is considered as a Roth IRA contribution up to the annual limit – which is $7,000 in 2024. It may take several years to roll over your 529 balance.
- Cash out the remaining balance. State and federal taxes will likely be due on the amount as well as a 10% penalty fee.
What if the child doesn’t attend college?
If the intended recipient decides not to attend college, the funds in the 529 can be used towards different educational pursuits, such as trade school or vocational schools e.g. cosmetology or culinary arts. In addition, the 529 plan could be transferred to another family member or relative — even a future grandchild. If no one plans to use the funds, they may be withdrawn with federal and state taxes being applied along with a penalty.
As you think about saving for college, it’s helpful to know what the average cost of higher education is today. Also, as parents move away from childcare expenses, it could be a good opportunity to take those childcare funds and begin saving for college. You can use our college savings calculator to help determine how much the anticipated future cost of college might be.
