What Is a 529 Plan? All You Need to Know

• A 529 plan is a tax-advantaged savings plan designed to cover qualified education expenses.
• Beneficiaries can hold multiple 529 plans and use the funds within to cover qualifying expenses, including tuition and fees, college textbooks and more.
• Contributions to a 529 plan may be subject to the gift tax and impact whether a student qualifies for need-based financial aid. 

Saving for college can be costly for families and students at all stages of life. And generally, the earlier you start saving for school-related expenses, the better. While your strategy for college might involve multiple financial options, including student loans, many families finance some of their children's education with personal savings. 

One tool for building college savings is a 529 plan. A 529 plan is a state-sponsored investment account that allows families to save for higher-education expenses. Legally known as “qualified tuition plans,” 529 plans grow tax-free and provide tax-free withdrawals when used for qualifying education expenses. 

There are different types of 529 plans, and this guide will help you better understand how each one works, as well as things to consider before opening a 529 account.  

Types of 529 saving plans

There are two main types of 529 savings plans: college savings plans — also called education savings plans — and prepaid tuition plans. Each works differently, and your options may vary depending on the state in which the account is opened. 

College savings plans

A college savings plan is a tax-advantaged savings account designed to help cover education expenses. Account holders have a number of investment options and can invest their funds to generate returns. Money invested into the account can grow tax-deferred, which means applicable taxes will be levied in the future. With 529 plans, however, funds (including gains) may be withdrawn tax-free as long as they're used for qualifying educational expenses. 

Qualified educational expenses may include:

• Tuition and fees at colleges, universities and K-12 schools
• Books, computers and internet access for college
• Room and board during college
• Special-needs equipment for college
• Student loans, up to a lifetime limit of $10,000
• Qualified costs for apprenticeship programs

Prepaid tuition plans

Prepaid tuition plans allow account holders to prepay tuition at today’s rates at eligible post-secondary institutions. Historically, tuition costs have significantly outpaced the rate of inflation, making prepayment a cost-effective option. Some, but not all states, also provide a guarantee that a prepaid plan will keep pace with tuition. 

Despite their advantages, prepaid tuition plans are less flexible than college savings plans. They can only be used to cover tuition at an eligible public or private college or university. Furthermore, prepaid tuition programs are paid to specific schools, which may limit the family’s options as the beneficiary becomes eligible to use the funds.

Unlike 529 college savings plans, they can't be used to cover other education-related expenses, such as college textbooks.

How does a 529 plan work?

529 plans vary by state, so it’s essential to explore and understand the 529 options within your area. However, 529 plans share key similarities across several states.

Opening a 529 plan allows you to save money for future education expenses. They offer tax-deferred savings, and gains are not subject to annual income or capital-gains taxes.

Withdrawals may also be made tax-free, as long as the money is used to cover qualifying educational expenses. These include tuition and fees at K-12 or post-secondary institutions and may include room and board, books, computers, internet access and special-needs equipment in college. 

Qualifying for a 529 plan 

Anyone can open a 529 plan and name themselves — or anyone else — as the beneficiary. Those wishing to save for their own education can open an account with themselves as the beneficiary. Third parties — such as parents, grandparents and other loved ones — can open 529 plans, listing their loved ones as beneficiaries, or they can simply contribute to another 529 plan. 

A beneficiary can have multiple 529 plans. However, state and federal governments may limit annual or lifetime contributions or the amount of contributions that can be made tax-free. 

529 savings contributions

Each state has its own regulations governing 529 plans, and contribution limits vary depending on the state in which the account is opened. North Dakota, for instance, allows a maximum contribution of $269,000 per beneficiary, while Massachusetts allows up to a total of $350,000.

There are generally no annual contribution limits to 529 plans, and those looking to maximize their college savings can contribute via regular deposits or payroll deduction. Furthermore, third-party contributions to a 529 plan count towards the annual gift tax contribution for the year and could be subject to a gift tax. For 2022, the annual gift tax contribution limit is $16,000.

529 plan penalties 

Beneficiaries can withdraw money from a 529 plan or qualified tuition program tax-free, as long as the money is used for qualified education expenses. However, other withdrawals are subject to 529 costs and penalties. If you make a non-qualified withdrawal, you’ll need to pay income tax on the withdrawal, as well as a 10% penalty. 

Advantages and disadvantages of 529 plans

Opening a 529 plan for a beneficiary can be a helpful method for financing higher education expenses, as well as K-12 expenses, in some cases. However, it can also have disadvantages, so it’s important to know the pros and cons to decide if it’s the right option for you. 

Advantages of 529 plans:

• High contribution limits allow for aggressive savings.
• Interest and other gains made on 529 contributions are tax-deferred, and distributions are tax-free, as long as the money is used for qualifying educational expenses or programs.
• There may be tax benefits, as contributions may be eligible for a state tax deduction.
• Anyone can open a 529 plan, and a beneficiary can have multiple 529 accounts. 

Disadvantages of 529 plans:

• 529 investment options are often limited, compared to other investment vehicles.
• The money must be used for qualifying expenses to avoid taxes and fees.
• 529 plans come with fees, which may include account maintenance, management and investment fees. 

For many, the benefits of a 529 may outweigh the disadvantages. If you’re interested in further exploring 529 plans, there are resources available to help. 

Is a 529 plan right for me?

A 529 allows you to start saving money toward your child’s future education costs or begin funding your own education. Saving aggressively using a 529 plan ensures your family will have funds available to help cover education expenses without relying solely on federal aid or student loans. 

Those interested in opening a 529 plan should first explore the options available in their home state. However, you may have options in other states, as well. First Republic Private Wealth Management can help you find the best plan to meet your needs. 

No matter how you choose to save for the future, planning early and taking the time to fully understand your options can help you reach your financial goals.