So you’re thinking about how your family will pay for your child’s college. That’s smart! It’s never too early to start. You may have heard of a 529 college savings plan and might be wondering what it is and what makes it different from a regular savings account. Or maybe you heard that it’s a type of “investment” account, and you’re not sure if that’s right for you.
Don’t worry. We’ll cover everything from “are 529 plans worth it?” to benefits, drawbacks, and comparisons to other savings methods.
Understanding 529 Plans
Let’s start with the basics. A 529 plan is a tax-advantaged investment account designed to help families save and pay for a college education, graduate school, or another form of higher education. In this case, “tax-advantaged” means your contributions grow tax-free while in the account. You can take out the money and pay no federal income tax if the funds are used for qualified education expenses.
As of 2023, 30% of all college savings are in 529 plans – more than any other savings method. On average, Americans have saved $27,741 in their 529s, and many of the families who are saving still have very young children, not even close to college age.
How Does a 529 Plan Work
A 529 plan is similar to other investment accounts, like an IRA or 401k plan. Instead of investing for retirement, you’re investing to pay for higher education. You can open a 529 plan account with whichever brokerage firm you want. Almost all states have 529 plans with tax breaks for state residents.
It’s important to note that you’re not limited to your own state’s plan—and your chosen plan does not impact where the beneficiary can go to school. They don’t need to choose an in-state school.
You can choose age-based investment strategies that evolve as your beneficiary approaches college age. Or you can create a customized mix of investment options based on what’s available through your brokerage firm. Like any investment, there is some risk, and 529s experience market fluctuations that affect their value over time.
Opening and Contributing to a 529 Plan
Anyone over 18 who wants to save for higher education can open a 529 plan — for themselves or someone else. Usually, parents open accounts with their children as beneficiaries. However, family members, like grandparents, can open them to save for their grandchildren. If you open a 529 plan for someone who decides not to pursue higher education, you can change the beneficiary at any time. The account owner always remains in charge of the money.
Most 529 plans have very low minimums required to open an account—some as low as $0. The best way to contribute is to make it automatic, with recurring contributions straight from your bank account or paycheck every month – or whatever works for you.
Benefits of Investing in a 529 Plan
There are many benefits to using a 529 plan, like federal income tax benefits and state tax deductions. Plus, 529s offer several advantages compared to traditional savings accounts and other methods of saving for higher education.
Tax Advantages of a 529 Plan
Federal income tax benefits
The largest benefit of 529 plans is that your investment has the potential to grow and can later be withdrawn free of federal income tax. That means you don’t have to pay federal income tax on earnings from your investments. When it’s time to pay for higher education, the money in the account can be withdrawn tax-free to pay for qualifying expenses.
State tax deductions
Many state 529 plans offer annual tax breaks for plan participants, which means you may be able to deduct your 529 contributions from your earned income for state income tax purposes. To be eligible for a tax deduction or credit, you must live and file your taxes in the same state that manages your plan. Nine states do not have income tax and, therefore, don’t offer 529 state tax deductions.
Other Benefits of Investing in a 529 Plan—Jumpstart a Roth IRA
Here’s another upside of 529 plans you might not have known about. Starting in 2024, if you have a 529 plan and no longer need the funds for education expenses, you can move up to $35,000 in total into a beneficiary Roth IRA (Individual Retirement Account) without paying taxes or penalties.
When moving money from a 529 plan to a Roth IRA, you must follow the IRS rules. The 529 account must have existed for at least 15 years to avoid penalties for moving funds. And you can only move over a certain amount at a time, up to the yearly limit. The 2024 annual limit is $7,000 ($8,000 if you’re 50 or older). It’s important to note that the person you’re saving for must have earned money equal to what you’re transferring each year.
This is a big win! If you were thinking, “if my beneficiary doesn’t pursue higher education, is a 529 plan a waste?” It’s not a waste now that increased flexibility allows unused funds to be put toward a retirement account.
How Do 529 Plans Compare to Other Types of Accounts?
Traditional savings accounts
If you’ve just started saving for your child’s higher education and you’re putting money into a savings account—that’s a good start. But don’t stop there! As of April 2024, the Federal Deposit Insurance Corporation (FDIC) listed the average interest rate on a traditional savings account at just 0.46%. That’s not great – to say the least. With a traditional savings account, your money is stagnant, earning almost no interest.
A 529 plan invests your money based on your specific goals, risk tolerance levels, and timeline. There’s much more growth potential with a 529 plan than with a traditional savings account. And let’s face it, college costs haven’t shown signs of dropping.
Impact on Financial Aid Eligibility
Don’t forgo investing in a 529 plan because you’re worried it will make your beneficiary ineligible for federal financial aid.
Yes, it generally affects their eligibility for need-based financial aid. But what’s the alternative? Save nothing and hope your child gets a full slate of need-based aid? It’s not a great move. Oftentimes, a large amount of the financial aid students are offered is in the form of federal student loans, which need to be paid back with interest. So, while those student loans can be helpful, they’re still debt.
One way to minimize the impact of a 529 plan on financial aid eligibility is for you, the parent, to own the account, with the student as the beneficiary. When a parent owns a 529 plan for their dependent student, the 529 plan is considered an asset of the parent, which can reduce financial aid eligibility by up to 5.64% of the asset value. If a student owns the account themselves, it would be counted as a student asset and may reduce financial aid eligibility by 20% of the asset value.
Another strategy for minimizing the impact of a 529 on financial aid is the ” grandparent loophole,” which allows non-parents to help pay for a student’s education without affecting their financial aid eligibility.
Drawbacks and Limitations of a 529 Plan
When considering investing for college with a 529 plan, you need to understand the drawbacks and limitations along with the benefits.
The main limitation is that 529 funds should be used for qualified education expenses, like college or vocational school tuition, books, supplies, a computer, and room and board. Funds from 529 plans can even be used for K-12 tuition, with a $10,000 limit annually.
Penalties for Non-Qualified Withdrawals
A 529 plan is intended for higher education, not saving for a new car or vacation. You can take distribution of funds from the account at any time if you need to. However, a penalty tax (generally 10%) will be applied to the earnings from your investments. Plus, some education-related costs are still considered non-qualified expenses that you’ll want to be aware of, like college application and testing fees.
Limited Flexibility in Investment Options
If you’re a personal finance expert or an experienced investor who prefers to take a more hands-on approach to investing, a 529 plan might be limiting.
When you set up a 529 plan, you choose from a selection of strategies for investing instead of choosing specific stocks or bonds. When you add money to the plan, it gets invested based on what you chose initially. A 529 plan isn’t like a regular investment account where you buy stocks yourself. Instead, the money in the plan gets invested in the stock market and grows as the market moves. You can pick different mixes of investments based on the beneficiary’s age and choose between safer or riskier options.
529 Plan Vs. Other Education Funding Options
If you’re considering a 529 plan, you may have heard about other popular ways families save and invest for higher education, like Coverdell ESAs and UGMA/UTMA accounts. Here’s how they compare:
Coverdell ESA
Like 529s, Coverdell Educations Savings Accounts (ESA) are tax-advantaged investment accounts. The main difference is that 529s can be used to pay up to $10,000 annually in K-12 tuition.
Coverdell ESAs also include qualifying expenses for K-12 education, like books, supplies, tutoring costs, and other special services related to enrollment at an eligible school. If you’ve got a pricey private elementary or high school in mind for your kids, a Coverdell ESA might be right for you.
Additionally, Coverdell ESAs generally have lower contribution limits. They do not allow for any more contributions after the beneficiary reaches 18 years old, whereas 529s do not have age limits.
UGMA/UTMA
The major differences between a Uniform Gifts to Minors Act (UGMA ) or Uniform Transfer to Minors Act (UTMA)and a 529 plan relate to account ownership and control, tax impact, and effect on financial aid.
UGMAs and UTMAs are controlled by a custodian until the beneficiary reaches the age of majority (in most states, that’s 18 years old). Unlike 529 plans, which are intended to be tax-free, taxes are paid annually on any earnings.
UGMAs and UTMAs are also considered the child’s assets. They are taxed at the child’s tax rate and are reported as the child’s asset when submitting the FAFSA. That means they could reduce financial aid eligibility by 20% of the asset’s value. Comparatively, 529 plans are reported as a parent asset and can reduce financial aid eligibility by up to 5.64% of the asset value.
Another important distinction is that, unlike with a 529 plan, you can’t change the beneficiary of a UGMA or UTMA.
In other ways, UGMAs and UTMAs are more flexible. For example, there are no contribution limits, more investment options, and permitted uses are not limited to educational expenses.
Evaluating the Best Option for You
There are benefits and drawbacks to all of these methods. Here are some important questions to ask yourself when thinking about which might be the best option for you:
- Am I committed to saving for higher education? Or do I want flexibility to access funds for K-12 education or other expenses?
- How concerned am I that my choice might impact my student’s eligibility for federal financial aid?
- Do I want full control over this account, or would I like it to transition to a beneficiary once they reach the age of majority?
- Do I want the ability to change my beneficiary at any time, even to myself?
- If my beneficiary does not need these funds for college expenses or other higher education costs, would I still like to invest for their future by moving funds into a Roth IRA?
So, Are 529 Plans Worth It?
A 529 plan is not the only way to save for higher education. And 529s are indeed investment accounts, and any form of investing comes with some risk.
However, there are plenty of 529 plans to choose from, often with tax benefits for residents who choose their state’s plan. Investments grow tax-free, and funds are withdrawn tax-free when used for education expenses. Plus, you always have the option to change your beneficiary entirely — or transition the funds into a Roth IRA for their retirement. More and more families are realizing the benefits of 529s and making them part of their saving-for-college plan.
