529 Plan: What It Is and How It Works

Paying for college can be stressful for many families. In 2023-24, the average cost of attending a 4-year, in-state public college was $28,840, compared to $60,420 at a private institution, according to the College Board. 

But a 529 plan can potentially lower the cost by offering a tax-advantaged way to save for education expenses. Keep reading for an overview of 529 plans and why you might want to consider opening one. 

What is a 529 plan? 

A 529 plan, officially known as a qualified tuition plan (QTP), is a kind of investment program with a specific goal: to fund future educational expenses. A state, a state agency, or an educational institution may sponsor these plans.

The appeal of 529 plans over other types of savings accounts is their tax benefits. The money in a 529 account grows tax-free, and withdrawals are tax-free when used for qualified education expenses. (Note that this applies to federal income tax — states may tax your withdrawals.) But many states provide tax breaks to residents who make contributions to their state’s 529 plan — usually in the form of a tax deduction or tax credit. This means more of your money goes toward education rather than to taxes. 

Types of 529 plans

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

1. Education savings plans

Education savings plans let you open an investment account to save for future education costs, such as tuition, mandatory fees, room and board, and other qualified expenses at any accredited institution — not just within your state or a participating group of colleges.

Because education savings plans are more popular and widely available than prepaid plans, the rest of this article will focus specifically on 529 education savings plans.

2. Prepaid tuition plans

Prepaid tuition plans allow you to buy credits at participating colleges and universities for future tuition at today’s prices, effectively locking in current rates. 

Prepaid tuition plans are less flexible than education savings plans because they may require participants to be a resident of the state to participate in a plan, and tuition credits can only be used at an in-state university or another participating college. If the student decides to attend a non-member college, there are limitations on how much the plan will pay.

Related: How To Pay for College: 10 Strategies

Pros and cons of 529 plans

Saving for college with a 529 education savings plan offers several benefits, but keep in mind that they come with certain limitations. 

Benefits: 

• High contribution limits: 529 plans allow for high contributions unlike some other tax-advantaged savings accounts. Contribution limits vary by state and can reach as high as $550,000 per beneficiary. Better yet, earnings on these contributions may exceed your plan's limit. Just keep in mind that contributing more than the annual gift tax exclusion — currently $18,000 for 2024 — could trigger the need to file a gift tax return. 
• Option to change the beneficiary: If the designated beneficiary on the account doesn’t need the funds for education, you can change the beneficiary to another immediate family member without penalty.
• Flexibility and ease of use: Opening and contributing to a 529 plan is straightforward, with many states offering the ability to start an account online. You can also automate contributions, making it easier to build savings over time.
• Potential tax breaks: If your state offers a tax incentive for contributing to its 529 plan, you may be able to deduct your contributions on your state income taxes. 

Limitations: 

• Limited investment options: Unlike a regular investment account, a 529 plan's investment choices are limited to the options provided by the plan. This can restrict your ability to tailor your investment strategy.
• Potential impact on financial aid: For the beneficiary, assets in a 529 plan can affect eligibility for need-based financial aid, such as federal grants, work-study, and subsidized student loans. 
• Penalties and taxes: If you withdraw money from a 529 plan for nonqualified expenses, the withdrawal counts as taxable income, and you could face a 10% federal tax penalty on the earnings portion of the withdrawal.

Related: Is Student Loan Interest Tax Deductible?

How to choose the right plan 

Choosing the right 529 plan requires careful consideration to ensure it aligns with your financial goals and educational aspirations. Here’s how to get started:

1. Research available plans: Start by exploring the 529 plans offered by your state. While you’re not limited to your own state’s plan, there may be tax advantages or other benefits for residents. Compare the features, benefits, and investment options offered by different plans.
2. Consider tax benefits: Evaluate the state tax benefits associated with each plan. Some states offer tax deductions or credits on contributions for residents who participate in the local plan, which can enhance your savings.

How to open a 529 plan

Once you've chosen a 529 plan, opening an account is straightforward. Most plans offer online enrollment, so all you need to do is complete the online application process. 

You’ll also be required to: 

1. Name a beneficiary: Decide who the plan beneficiary will be. This can be a child, a grandchild, another family member, or even yourself. You can change the beneficiary in the future if needed.
2. Set up contributions: Determine how much you can afford to contribute initially and as ongoing contributions. Many plans allow you to set up automatic monthly transfers from your bank account, allowing you to put your college savings on autopilot.
3. Select an investment strategy: Choose your investment options based on your risk tolerance and the beneficiary’s time frame for starting their education. Most plans offer a range of investment portfolios, including age-based options that automatically adjust the investment mix as the beneficiary approaches college age.
4. Monitor and adjust as necessary: Keep an eye on the account’s performance and the changing needs of your beneficiary. You may need to adjust your contributions or investment strategy over time to stay on track with your savings goals.

What if I have money left in my 529 plan?

A common concern for families investing in a 529 plan is the possibility of having unused funds, whether due to scholarships, a decision not to attend college, or simply efficient saving and investing.

Fortunately, you have several options for dealing with the leftover money:

• Take advantage of tax-free contributions for scholarships: If your child receives a scholarship, the money in a 529 plan can be used for other expenses not covered by the scholarship, such as room and board, mandatory fees, books, computers, and related equipment. If you still have leftover funds, you can withdraw up to the same dollar amount as the scholarship from the plan. You will owe taxes only on the earnings portion of the withdrawal and won’t have to pay a 10% penalty.
• Save it for graduate school: You can leave the funds in the 529 plan in case the beneficiary decides to pursue further education later, such as graduate or professional school. 
• Change the beneficiary: One of the most straightforward solutions is to change the beneficiary to another family member who can use the funds for their education. This can include siblings, cousins, children, nieces, nephews, or even yourself.
• Roll into a Roth IRA: You can roll over up to $35,000 from a 529 plan into a Roth IRA for the same beneficiary. However, annual Roth IRA contribution limits apply, and you can only roll over up to $7,000 in 2024. 
• Withdraw for nonqualified expenses: If there’s no foreseeable educational use for the remaining funds, you always have the option to make a nonqualified withdrawal. However, it’s important to note that the earnings portion of your withdrawal will be subject to federal and state income taxes and a 10% federal tax penalty. 
• Transfer to an ABLE account: For families with a member who has a disability, it’s possible to roll over funds from a 529 plan to an Achieving a Better Life Experience (ABLE) account without penalty, up to the ABLE account contribution limit — $18,000 in 2024. ABLE accounts are tax-advantaged savings accounts for individuals with disabilities and their families, offering a way to use the funds for qualified disability expenses, including housing, transportation, employment training and support, and education, among others.

The bottom line

A 529 plan can be a great investment if you have a long-term goal to save for education expenses and you can afford to set aside money for future education costs. 

Additionally, combining 529 funds with other forms of aid that don’t require repayment can be a smart strategy to minimize student debt. If you still need funding after using 529 savings, scholarships, and grants, then federal and private student loans can help you cover any remaining costs. 

529 plan FAQ

How much does a 529 plan cost? 

A 529 plan's cost varies depending on several factors. There may be an enrollment fee, especially if you're joining an out-of-state plan. Annual maintenance fees range from $10 to $50, although these are sometimes reduced or waived based on certain criteria (state resident, automatic contributions, maintaining a minimum balance, etc.). Some plans also charge an annual administration fee that’s calculated based on a percentage of your 529 account balance. Lastly, if your chosen plan includes mutual funds, underlying fund expenses may also apply. 

What types of expenses does a 529 plan cover? 

A 529 plan can be used to cover various educational expenses at an accredited institution, such as: 

• Tuition
• Fees
• Room and board
• Books and supplies 
• Technology and equipment 

Keep in mind that if you use 529 funds money for nonqualified educational expenses, you'll risk a 10% tax penalty.

Does a 529 plan impact financial aid eligibility? 

A 529 plan can impact your eligibility for financial aid, depending on who the account owner is. When applying for financial aid via the FAFSA, the amount of aid you’re eligible for is calculated based on your family’s income and assets. 

If a 529 plan is owned by a dependent student or their parent, the funds are considered a parent asset on the FAFSA. However, if the account is owned by a non-parent (such as the student’s grandparent), a 529 plan is reported as money received or paid on the student's behalf. 

Related: How Much Money Will FAFSA Give Me?