Understanding 529 Plans: How They Work and How To Use Them

A 529 account presents one tax-advantaged method for parents to save for college. Although more parents use a general savings account, 529s are the second-most popular way to save. Savings in a 529 plan account for 30% of all college savings in terms of dollar amount, representing more than any other form of savings.

Here's a closer look at what a 529 plan is, 529 plan tax benefits, and how to open a 529 plan.

What is a 529 plan?

A 529 plan is a tax-advantaged savings account built for the express purpose of saving for educational costs. Put into place through Section 529 of the Internal Revenue Code, 529 plans are considered qualified tuition plans. State governments, agencies, and educational institutions sponsor these plans.

There are two types of 529 plans: savings plans and prepaid tuition plans.

529 savings plans vs. prepaid tuition plans

A 529 savings plan allows families to save for college. Within the 529 account, the contributions grow at a tax-free rate. When college rolls around, the amount of money available in the account is based on the amount you've saved and the investment earnings your contributions generated. In contrast, a prepaid tuition plan involves paying the current tuition rates for your future college student and getting course credits or units to be used at a later date.

Generally, a 529 prepaid tuition plan is less flexible than a 529 savings plan. If your student doesn't attend one of the colleges compatible with the prepaid tuition plan (usually in-state public schools, though some private colleges participate), you can typically still use the money to help pay for school. However, the amount you receive back from an unused prepaid tuition plan varies from plan to plan.

Current private student loan rates

How does a 529 plan work?

A 529 plan is designed to reward parents who save for their child's education within this type of account.

In many states, this type of college savings plan comes with tax benefits. Specifically, you may be able to deduct your contributions from your state income tax. The earnings aren't subject to federal income taxes if you withdraw funds for qualified education expenses. Tax-free earnings benefits also apply in many states.

If you start early, funds invested through a 529 account may grow significantly. When it's time to withdraw the funds, you'll need to spend them on qualified higher education expenses to avoid any taxes and penalties.

Qualified expenses for 529 plans

To withdraw the funds tax-free, you must use the money to pay for qualified education expenses. Some qualified expenses include:

• Tuition for K-12 education: If you send your child to a private school, this expense may qualify for a tax-free 529 withdrawal. The annual withdrawal limit for this purpose is $10,000.
• Higher education expenses: These include the required costs to attend a college, university, vocational school, or other qualified educational institution. Required costs might include tuition, fees, on-campus housing, textbooks, and laptops. Expenses that don't qualify might include insurance, medical costs, transportation, and other living expenses.
• Student loan repayment: A plan's beneficiary or sibling may withdraw funds to pay off student loans, up to a lifetime limit of $10,000.

529 plan tax benefits

Tax benefits represent the main appeal of saving for college through a 529 plan vs. other savings accounts.

• Federal tax benefits: The earnings produced in your 529 account aren't subject to federal income tax.
• State tax benefits: Many states allow savers to deduct their contributions to a 529 plan from their state income taxes. Additionally, the earnings within a 529 account might not be subject to state tax.

While these tax benefits are undeniably attractive to savers, the catch is that you could be on the hook for taxes and penalties if you make nonqualified withdrawals. When you withdraw funds for a nonqualified expense, you'll pay federal and state income taxes and a 10% federal tax penalty on earnings.

529 to Roth IRA rollovers

A 529 plan offers many perks. But if your child doesn't use some or all of the funds for college, withdrawing the rest of the funds comes with a hefty tax penalty. Luckily, a recent change to the rules allows for penalty-free rollovers from a 529 plan to a Roth IRA for the same beneficiary.

There are some limitations. The 529 must have been open for at least 15 years, and the funds you roll over must have been in the 529 account for at least five years. Additionally, the maximum rollover amount is $35,000.

But this strategy offers a worthwhile way to conserve funds earmarked for your child's future.

How to open and manage a 529 plan

If a 529 plan sounds like a good fit for your college savings goals, the process starts by choosing between a state or private plan.

Opening a 529 plan

A direct-sold 529 is a plan sold directly by a state. Generally, you'll manage your own investments within the account through an online platform. In contrast, an adviser-sold 529 is sold through an investment firm. Typically, these 529s come with adviser fees because the firm manages the investments within your plan.

The right choice between a state or private plan boils down to your investment support needs, contribution options, and plan fees. Read the fine print of the options available to you in your state before committing to a particular 529 plan. As a guiding light, seek out a plan with limited fees to maximize your savings.

Managing a 529 plan

As you build savings in a 529 account, consider setting up an automatic, recurring contribution to put your savings on autopilot. Adding savings to your account regularly can add up quickly. Some employers and plans offer payroll direct deposit, which takes your 529 contributions directly out of your paycheck. If you want a streamlined approach, a payroll deduction might be a good option. Of course, you can also make one-time contributions along the way as your budget allows.

Changing your beneficiary

If you save more than needed for your child's education, you might consider helping someone else pay for school. You can change the beneficiary of a 529 account without negative tax implications if the new beneficiary is an eligible family member of the current beneficiary. Eligible family members include:

• Adopted children
• Natural children
• Parents or stepparents
• Siblings or stepsiblings
• Nieces or nephews
• Aunts or uncles
• The spouse of the beneficiary or of any other eligible family member
• First cousins

All in all, 529 plans offer ample tax benefits and some flexibility for savers looking to fund college costs for a child or relative.