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Updated on Friday, October 8, 2021
A 529 plan is a tax-advantaged savings account designed to help people pay for education-related expenses. These plans are administered at the state level, and each state offers different types of accounts with different specifications. Some states allow you to open 529 accounts offered by other states.
What 529 plans have in common is that money in these accounts grows tax-free and withdrawals for qualified educational expenses are also tax-free. These plans can often be used for a wide variety of expenses, though sometimes they’re restricted to paying for tuition. Those significant tax advantages are why 529 plans are a smart way to save for college.
How does a 529 plan work?
Parents usually open 529 accounts for their children, who are the beneficiaries of the accounts. Contributions aren’t capped on a yearly basis, but states have an upper limit on how much money can be contributed in total.
Funds in 529 accounts are often spent on higher education, but you may be able to pay for tuition to K-12 schools with these accounts in some states, as well. While some states allow 529 plans to be spent on education-related expenses like rent for college students, other states have stricter rules.
Rather than operating as a deposit account that earns a set amount of interest, many 529 plans are similar to investment accounts. Much like a Roth 401(k) or Roth IRA, which are popular retirement accounts, 529 plans invest in mutual funds and exchange-traded funds (ETFs) before qualified withdrawals can be made tax free.
Savings plans vs. prepaid tuition plans
Savings plans: Of the two types of 529 accounts, a savings plan is more common than a prepaid tuition plan. Money in this type of 529 plan can be invested in a variety of funds at the discretion of the account holder, and some of these accounts are geared toward safer investment strategies as the beneficiary approaches college age. Savings plans offer a broader range of qualified expenses than prepaid tuition plans, which are quite narrow.
Prepaid tuition plans: Some states offer future college credits for participating in-state colleges as part of their 529 plans. Residents of those states can lock in a lower price at the time of purchase. These funds are much less flexible than standard 529 savings plans, but as the cost of college continues to rise, purchasing credits early can result in significant savings.
Are 529 contributions tax deductible?
In some states, people can write off 529 contributions on their state income taxes up to a certain amount. New York, Michigan and North Dakota each offer up to a $5,000 state income tax deduction for 529 contributions, and Illinois, Mississippi and Oklahoma offer up to $10,000. Colorado and New Mexico offer deductions on the full amount of the 529 contributions. Not every state offers a deduction. Find the best 529 savings plan in your state.
Ultimately, the biggest tax advantage of the 529 account structure is that investments can grow untaxed and withdrawals can be made tax-free. The tax benefits are a nice bonus for those people who itemize their tax deductions and live in states that allow them.
What can 529 funds be used for?
Qualified 529 expenses include costs associated with post-secondary education. While some states and specific plans have restrictions on what counts as a qualified expense, common types include:
- Enrollment fees
- College tuition
- K-12 tuition costs
- Room and board
- Some off-campus living expenses
- Educational supplies
- Apprenticeship program costs
Be sure to check whether a particular expense is qualified as part of your 529 plan before withdrawing funds from the account. Withdrawals for non-qualified expenses can incur expensive penalties.
How much can I contribute to a 529 plan?
Again, states have different rules for 529 contributions, but all of them have a maximum aggregate contribution and no annual limit. California allows account holders to save up to $529,000 per beneficiary, but most states have lower maximums — Georgia is the lowest at $235,000.
State maximums tend to be pretty high — those saving for up to four years of in-state tuition will often fall well short of the highest amount they could possibly save.
How to set up a 529 plan
The first step to set up a 529 plan is to choose the plan that best fits your financial needs — a general savings account or a prepaid tuition plan. Next, you will need to decide whether you will open an individual account (with a parent as the account owner) or a custodial account on behalf of the beneficiary. You will also need to determine which kinds of 529 accounts are available, as well as whether they meet your criteria for investment strategy and risk tolerance.
Once you’ve selected your 529 account, you will need to complete an application with information for the applicant and beneficiary including mailing addresses, phone numbers, birth dates and Social Security numbers (SSN).
Once your application is approved, you can start contributing to your 529 plan.
What happens to a 529 if it isn’t used?
If there are funds remaining in a 529 account after the beneficiary is done with school and has no further education-related expenses, account holders have a few options. They can withdraw the funds and close the account without using that money for qualified expenses as long as they’re willing to pay taxes and penalties. Income taxes are levied on those withdrawals, as well as a 10% federal tax penalty and possible state taxes.
The account holder can also transfer the money to an eligible relative — for example, if there’s money left over after the eldest child goes to college, the money could be transferred to a younger sibling for college expenses.
Account holders are able to change their 529 beneficiary to certain relatives, including:
- Aunts and uncles
- Nieces and nephews
Is a 529 worth it?
A 529 plan is the best way to save for college if you know that you’ll be incurring education-related expenses in the future. Between tax deductions on contributions, untaxed dividends and the ability to make tax-free withdrawals, there are a lot of advantages to 529 accounts — even if they have restrictions on how the funds can be used. The transferability rules are a nice feature too; if the designated beneficiary of the account doesn’t need the money, someone else in your family might be able to use it.
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