The cost of higher education continues to rise. For the 2021-2022 academic year, total tuition and fees at public institutions for first-time, full-time students averaged $9,700, according to the National Center for Education Statistics. At private for-profit institutions and private nonprofit institutions, total tuition and fees averaged even higher at $17,800 and $38,800, respectively.
With costs this high, many families are looking for ways to start saving today for their loved ones’ future educational expenses. One of the most tax-efficient ways to do that is with a 529 savings plan.
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What is a 529 college savings plan?
A 529 plan, also sometimes called a qualified tuition program or Section 529 plan, is a tax-advantaged way to save for qualified higher education expenses.
Broadly, 529 plans fall into two buckets: prepaid tuition plans and savings plans. Here’s the difference:
- Prepaid tuition plans: These plans allow a contributor to prepay the qualified higher education expenses of a beneficiary and are typically offered for specific colleges or college systems. These plans typically require the beneficiary to be a resident of the state offering the plan.
- Savings plans: These plans allow for contributions to be made to an account that makes investments for paying for qualified higher education expenses in the future. These plans are similar to retirement plans like an individual retirement account (IRA) or 401(k) where the value can go up and down over time.
The plans are generally administered by states or agencies. In the case of prepaid tuition plans, they may also be run directly by eligible educational institutions.
529 savings plans also have two sub-categories:
- Direct-sold plans are sold directly by either the state or a financial institution, and the investor is responsible for making their own investment decisions.
- Advisor-sold plans are sold through an investment firm, and typically a financial advisor manages the plan’s investments.
Benefits of a 529 savings plan
Contributions to a 529 savings plan do not generate a federal income tax deduction, but earnings inside the plan grow tax-free. To benefit from the tax-free growth, distributions must ultimately be used to pay for qualified higher education expenses. This allows taxpayers to have more money to cover those expenses than they would save in an account that was not tax-advantaged.
“I am often asked by clients if they get a tax deduction for contributing to a 529 plan for their child,” said Evelyna Caldwell, certified public accountant and owner of Balanced CPAs, LLC. “The answer is that the contributions are not tax-deductible. This makes them wonder why they would do it, and I explain that as the account balance grows over time, the earnings are not taxed, and when money is withdrawn for qualified purposes, the entire withdrawal is also tax-free.”
When it comes time to withdraw the funds, you need to be careful you are meeting the criteria of a qualified withdrawal, Caldwell said. If there is a non-qualified withdrawal, the earnings portion will not only be taxable, but it will also be subject to a 10% penalty.
As a simplified example of how the tax benefit works, assume a contributor has $10,000 to invest into either a 529 college savings plan or into a taxable account for their beneficiary. Further assume that all distributions from either account will be used to pay for qualified higher education expenses, that the investments will increase, net of fees, by $5,000 before they are distributed and that all earnings in the taxable account are subject to a 20% income tax rate.
As you can see in the table, since all the earnings in the 529 savings plan are tax-free, that means all contributions and earnings are available to cover qualified higher education expenses. Whereas in a taxable account, a portion of the earnings — $1,000 in this example — must be used to cover taxes on the earnings, meaning less is available to cover higher education costs.
How to start a 529 savings plan
Since 529 savings plans are generally administered by states, the first step is figuring out which state or states have a plan the contributor would potentially want to invest in. It may be wise to start by looking at options offered in the state where the contributor or beneficiary lives. Some states also offer their residents a tax deduction for contributions to 529 savings plans so individuals should carefully consider what personal benefits they may qualify for. Charles Schwab offers a calculator to help contributors determine what they may be eligible for.
Contributors should also confirm whether the specific plan they are considering allows the funds to be used for higher education expenses outside of the state sponsoring the plan.
Qualified higher education expenses
To gain the full benefits of a 529 plan and be tax-free, distributions from a 529 savings plan must be used to cover qualified higher education expenses. Details on which expenses qualify can be found in IRS Publication 970.
Here is a summary of which expenses qualify:
- The following expenses when required for enrollment at an eligible postsecondary school:
- Tuition and fees
- Books, supplies and equipment
- Expenses for special needs services needed by a special needs beneficiary when incurred for enrollment at an eligible postsecondary school
- Expenses for room and board incurred by students who are enrolled at least half-time, additional limitations apply
- The purchase of computer or peripheral equipment, computer software and related services when used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible postsecondary school. Additional restrictions limit this benefit as well
- Expenses for fees, books, supplies and equipment required for the designated beneficiary’s participation in certain apprenticeship programs registered and certified by the Secretary of Labor
- Cumulatively up to $10,000 of principal or interest on qualified student loans of either the designated beneficiary or their sibling. Step siblings are considered siblings for this purpose
- Annually up to $10,000 of qualified elementary and secondary education expenses
Tax implications of a 529 plan
If distributions from a 529 plan do not meet the list of qualified expenses, you may be subject to both income tax and a 10% penalty on the earnings portion of the non-qualified distribution.
The formula for figuring out the taxable portion is provided in IRS Publication 970, but the gist of it is that you must prorate the distribution both across qualified and non-qualified portions and between contributions and earnings in the plan to determine the taxable amount. Several exceptions to the penalty are also available, for example, if the designated beneficiary is disabled.
Starting in 2024, eligible beneficiaries can roll over a portion of their 529 plan balance to a Roth IRA tax-free. When available, this is an excellent way to avoid the potential taxes and penalties on excess funds still in a 529 plan after all college costs have been paid and to help the beneficiary start saving for retirement.
Choosing a 529 savings plan
Before picking a specific plan, contributors should carefully consider several factors including the plan’s fees, investment options, contribution options, contribution limits and withdrawal restrictions. The investment options are typically fairly limited in a section 529 savings plan and may only be changed twice per year, or when the beneficiary is changed.
College Savings Plans Network offers a 529 plan search tool that allows users to search various plans on different dimensions including direct-sold vs. advisor-sold and asset-fee ratios, among many others.
While direct-sold plans generally cost less in fees, advisor-sold plans do make sense for certain situations, like rare states that have better plan options for advisor-sold, you want more investment options than a direct-sold plan or if you have a financial advisor you’re comfortable with and would like to pay to help in college savings.
Frequently asked questions (FAQs)
Distributions from a 529 plan can technically be used for any purpose, however, the earnings portion of any distributions not used to cover qualified higher education expenses are potentially subject to both income taxes and a 10% penalty. See IRS Publication 970 for more details including available penalty exceptions.
Even if a beneficiary does not go to college, they may still be able to benefit from a 529 plan. Qualified higher education expenses also include up to $10,000 per year in qualified elementary or secondary expenses as well as certain apprenticeship programs registered and certified with the Secretary of Labor. Other potential options also include rolling funds into a Roth IRA for the beneficiary, changing the beneficiary or taking distributions that may be subject to taxes and penalties.
Yes, the beneficiary of a 529 plan can be changed. If the designated beneficiary of an account is changed to a member of the beneficiary’s family there are no income tax consequences. Members of the beneficiary’s family are defined broadly to include:
- Son, daughter, stepchild, foster child, adopted child or a descendant of any of them
- Brother, sister, stepbrother or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother or sister
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law
- The spouse of any individual listed above
- First cousin
There are two types of contribution limits to consider related to 529 plans. The first is the contribution limit on the plan itself. These are generally structured as maximum balances allowed in the plan and are set separately by each state, so understanding the applicable limits before selecting an account is an important consideration. The Education Data Initiative maintains a database of contribution limits by state. The other limit to consider is the annual gift tax exclusion.
