Banking 101: What is a 529 College Savings Plan? Benefits and Alternatives

A 529 savings plan is a tax-advantaged account used to make investments to pay for future educational expenses. This guide will give you an overview of 529 college savings plans and help you prepare for one of the biggest life costs you’ll need to save up for.

How does a 529 savings plan work?

Named after section 529 of the Internal Revenue Code, 529 college savings plans are tax-advantaged investment accounts that let you save for education expenses. Plan holders make regular contributions over time, the balance is invested in the market and distributions pay education costs for a named beneficiary.

529 savings plan rules

• Contributions to a 529 college savings plan are made using after-tax dollars.
• Qualified distributions are entirely tax-free.
• Distributions may be used to pay for undergraduate college tuition and other costs, like room and board.
• In certain cases, distributions may be used to pay K-12 school tuition.

Many 529 plans are sold directly by states, although you may also open one with a financial advisor. Investments made in 529 plans are structured similarly to a 401(k): Investment portfolios are adjusted to the level of risk you’re comfortable with and the target date for when distributions need to be made, and the investments become more conservative over time as the beneficiary gets closer to school age.

The account is owned by you in your name, and one child is listed as the beneficiary. If the beneficiary gets a scholarship or decides not to attend college, you can name a different child as beneficiary, so long as they are an immediate family member — including nieces and nephews.

These savings plans were created for college savings in 1996 as part of the Small Business Job Protection Act. The 2017 Tax Cuts and Jobs Act changed the rules, allowing the funds saved in a 529 plan to pay for elementary and high school education costs as well. But after more than two decades, most people still haven’t heard of 529 plans: A survey conducted by investment company Edward Jones found that 71% of Americans don’t know what a 529 plan is.

529 plan contribution limits and withdrawal limits

There are no annual contribution limits set on 529 plans by the IRS, although states can impose their own maximum lifetime contribution limits. These can be as low as $235,000 or as high as $529,000, depending on the average cost of education in a given state. 

Annual 529 college savings plan contributions under $15,000 don’t need to be reported to the Internal Revenue Service (IRS). If you contribute more than $15,000 per year, or $30,000 per couple, the contribution must be reported to the IRS for gift tax purposes. 

You can contribute five years’ worth of funds in one lump sum — that’s $75,000 per person or $150,000 per couple — as a special option called superfunding. Keep in mind that this uses up your gift tax exclusion for five years.

There are no withdrawal limits for distributions used for post-secondary higher education, but there is a $10,000 annual withdrawal limit when funds are used for primary or secondary education. 

529 prepaid tuition plans vs. 529 education savings plans

There are two kinds of 529 accounts: prepaid tuition plans and education savings plans. With a 529 prepaid tuition plan, you purchase credits at participating colleges and universities — typically public institutions — at today’s prices, which are then used by the beneficiary in the future. A 529 education savings plan is an investment account where you save funds over time to pay for tuition and other expenses at any college or university, as well as some primary or secondary school tuition costs.

What is a 529 prepaid tuition plan?

A 529 prepaid tuition plan allows you to pay today’s tuition costs to cover tomorrow’s education. With a prepaid tuition plan, you’re paying costs now based on a college or university’s current rate, avoiding higher costs in the future. Prepaid tuition plans typically cannot be used to pay for room and board costs, and they do not allow you to prepay for tuition for elementary or secondary schools.

State governments typically sponsor prepaid tuition plans, which are managed by private investment firms. Some state governments guarantee investments in their prepaid tuition funds. 

The main downside of prepaid tuition plans is that they’re fairly limiting. For one, the funds can only be used for tuition and fees — not room and board or books, something that 529 education savings plans allow. If the plan’s beneficiary decides not to attend college, or wants to attend college at a different school in your state or in another state entirely, the plan may only return some of the original investment.

What is a 529 education savings plan?

With a 529 education savings plan, you open an account with a broker or investment firm. Distributions made from an education savings plan can be used to pay for tuition at any college or university, as well as room and board, and other expenses. Funds in education savings plans can also be used to pay for tuition at any public, private or religious elementary or secondary school, up to $10,000 per year per beneficiary.

With an education savings plan, you can choose among a range of investment portfolios, usually made up of mutual funds and exchange-traded funds (ETF). One downside of education savings plans is fees. They may charge an enrollment fee, annual account fees and asset management fees. Before committing to an education savings plan, you need to carefully evaluate and understand what kind of fees you will be paying.

529 savings plan pros

• Multiple tax advantages: Investment gains in 529 plans are not taxed. Plus, many states offer state income tax deductions for 529 contributions. 
• Flexible terms: If your child decides not to attend college or gets a scholarship, you can switch the beneficiary on a 529 account. 
• Funds can be gifted to the account: Parents and other family members can donate a tax-free “gift” of up to $15,000 to a 529 college savings plan. 
• You can use funds for different types of education: New rules allow for 529 education savings plan assets to be used not only for higher education but also elementary and high school education. 
• No federal contribution limits: Although states can impose their own aggregate limits, there are no contribution limits from the federal government.

529 savings plan cons

• Penalty for certain withdrawals: If you end up not needing the funds in a 529 plan and you can’t transfer them to another beneficiary, you may need to pay taxes on your earnings along with a 10% withdrawal penalty.
• Funds in 529 plans count when need-based financial aid is calculated: Even though 529s are factored into need-based financial aid calculations, only about 5% of the assets are accounted for, compared to 20% for traditional student-owned accounts.
• Certain 529 plans charge fees: There can be fees associated with 529 education savings plans, which can be high if you opt for an advisor-guided plan.

Tax advantages and disadvantages of 529 college savings plans

There are two primary tax advantages when it comes to 529 college savings plans: Investment earnings are not taxed, and the plans can yield state income tax deductions. 

Investment gains in 529 plans are not taxed. Let’s say you put $10,000 into a 529 and it grew to $12,000. As long as you used all of the money on education expenses, including things like room and board and books, you won’t need to pay taxes on your $2,000 gain. If you made the same gain in a savings account, you would need to pay taxes on the interest.

Because 529 college savings plans are typically state-sponsored, many states will deduct your contributions from your taxable income up to a certain limit. Currently, 34 states and the District of Columbia offer either full or partial income tax deductions for 529 college savings plan contributions, according to FinAid. 

The big tax drawback is that if you don’t use the funds for education expenses, you will need to pay taxes on your earnings, as well as a 10% penalty. As mentioned, many 529 plans also charge fees, which can be high if you opt for an advisor-guided plan. 

One other drawback is that funds in 529 plans are factored into a child’s Expected Family Contribution (EFC) when they apply for need-based financial aid. However, only about 5% of assets are accounted for, compared to 20% with traditional student-owned savings accounts. 

You don’t have to live in a state in order to use that state’s 529 plan. For example, if you live in New York, you could opt for a plan in California. Although a plan in another state might have lower fees and a better performance history, you might not be able to take advantage of that state’s income tax deduction. It’s important to weigh the pros and cons to figure out which plan is right for you. 

Alternatives to 529 college savings plans

The two main alternatives to 529 plans include the Coverdell Education Savings Account (ESA) and custodial accounts governed by the Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA).

ESA vs. 529 plan

A Coverdell Education Savings Account is another option when it comes to saving for your child’s college education. Like a 529, it can be used for elementary and high school education, as well as higher education. 

• There are several differences between ESAs and 529s. There is an annual contribution limit of $2,000 for ESAs, compared to no annual contribution limit for 529s.
• There are also income restrictions on ESAs, meaning you’ll be phased out of contributing once your income is $110,000 ($220,000 for joint filers).
• The funds in an ESA generally must be used by the beneficiary by age 30, whereas there is no age limit on 529s. 

Custodial accounts vs. 529 plans

Custodial accounts set up under the Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) allow parents to save money for their children until they reach a certain age. There are tax benefits associated with these accounts, as the first $1,000 contribution isn’t taxed. 

It's possible that the child won’t pursue higher education, but the funds can be used for anything. Although this offers a level of flexibility, many parents who are saving for their child’s education might see this as a drawback. 

“When the child reaches age 18, the money becomes legally theirs,” said Luis Rosa, a certified financial planner and founder of Build a Better Financial Future in Henderson, Nev. “And they don’t have to use it for college. At that point, they could say, 'Hey, I’m going to buy a convertible and there’s nothing you can do about it.'” 

What’s better: 529 plan or a savings account?

Some people will choose to save for their child’s college education using a regular savings account. One upside to this route is that the money saved can be used for anything at any time. If your child gets a full scholarship to college or decides not to attend, you can simply use the money for something else without paying a penalty. 

However, savings account contributions won’t grow as quickly as they would in a 529 account. Plus, it’s important to know that when a student applies for need-based financial aid, about 20% of student-owned savings account assets will be accounted for, compared to only around 5% with 529s. 

Should I use a 529 plan or a Roth IRA?

Another way to save for your child’s education is through a Roth individual retirement account (IRA). With a Roth IRA, your money could grow faster than it would in a 529, plus you won’t be forced to pay a penalty for withdrawing funds before age 59½, as education is considered a qualifying event. 

However, you can only contribute $6,000 per year ($7,000 if you’re 50 or older), whereas 529s have no annual contribution limit. Even though you won’t pay a penalty on a withdrawal, you will still need to pay taxes. In addition, Roth IRA funds that are withdrawn to pay for college will be considered income when a student applies for need-based financial aid, and income is weighted more heavily than 529 college savings plan assets.