An Overview of 529 Savings Accounts
Opening a 529 account may help prepare your child for the cost of higher education.
Worried about the cost of college? With the average cost for a bachelor’s degree at an in-state school totaling more than $104,000,1 saving for your child’s education may be on your mind.
One way to prepare for your child’s education is with a 529 account. These plans help you set money aside for their college and have some unique tax advantages.
Let’s look at how 529 accounts work and discuss ways to tell if they may be the right fit for your child’s needs.
529 accounts help parents and guardians save for their child’s future education expenses.
Funds are meant to be used for qualified education expenses. Funds used for other expenses may incur a tax penalty.
If your child doesn’t go to college or use all of the funds, you’re able to appoint a different beneficiary or roll them into a Roth IRA.
What Is a 529 Plan?
A 529 plan is a tax-advantaged college savings account that may be used to pay for educational expenses. All 529s have an account owner and a beneficiary, but the account’s ownership structure could be set up as an individual or custodial account.
In the custodial arrangement, the child is both the account’s owner and beneficiary, and an adult custodian manages the account on their behalf until they turn 18.2 With this structure, once the child turns 18, they take possession of the account’s funds and may use them to cover their qualified educational expenses.3 We’ll go over what counts as qualified educational expenses later.
When a 529 is set up as an individual account, the owner, usually a parent or guardian, saves money on behalf of the beneficiary. The owner makes contributions and investment decisions. In this arrangement, the account owner retains control over the account even after the beneficiary becomes an adult.4 Once the beneficiary enrolls in college, the account owner may withdraw funds to pay for qualified educational expenses.
529s allow you to contribute money and invest in different options like mutual funds, target-date portfolios, or exchange-traded funds (ETFs). These investments may help grow your savings faster, but they’re not without risk.
As an investment account, a 529’s performance is tied to the market, meaning if your investments do well, the balance increases. However, if the investments lose value, the account may also lose value.
529s don’t have annual contribution limits like Individual Retirement Accounts or 401(k)s, but they do have total account contribution limits ranging from $235,000 to $500,000, depending on where you live.5
Additionally, 529 contributions qualify as gifts according to the IRS. This means contributions over a certain threshold may be subject to the federal gift tax.6 Consult your tax advisor how this gift tax may apply to you.
Benefits of 529 Savings Accounts
Regardless of the savings vehicle, saving for college now could yield benefits for you and your child in the future.
For you, it could help relieve stress when college time rolls around (it comes faster than you think) and you know you have money set aside. And having savings may help your child avoid or reduce the need to borrow for college: the average undergraduate student borrows more $37,000 for their bachelor’s degree!7
529 plans are one of the more popular ways to save for college. Here’s are some benefits you have access to when you open a 529 account for your child:
Tax advantages: Contributions to 529s are made with post-tax dollars, but you may be able to deduct these contributions from your state income taxes (check with your tax advisor on how this may work for you). The biggest benefit is when 529 funds are used for qualifying education expenses, as the earnings aren’t subject tax.
Potential for increased savings: Since the money in the 529 account gets invested and grows tax free, there’s potential for the funds to grow faster than in a regular savings account. Keep in mind that there’s always a risk that the investments may lose value and reduce the account’s balance.
Minimal impact on financial aid eligibility: 529 accounts generally have a minimal impact on a student’s eligibility for need-based financial aid.8 The impact depends on who owns the account and how the money is distributed. It’s best to consult a financial advisor to determine which ownership and distribution structure works best for your situation.
Types of 529 Plans
When opening a 529 account for your child, you’ll want to consider which type of account to open: a standard 529 plan, a prepaid tuition plan, or a private prepaid tuition plan.
While all three types of 529 accounts may help you save money for your child’s education, they work in different ways.
Standard 529 Plan: Standard 529 plans, AKA college savings plans, let you make after-tax contributions to the account and invest the money according to the guidelines of the account. There are no restrictions on the schools where funds could be used, but the funds must be used for qualified expenses.
Prepaid tuition plans: Prepaid tuition plans let you prepay tuition for public in-state colleges and universities at current tuition rates, helping you hedge against potential tuition increases by the time your child enrolls. These funds may be converted to a standard 529 college savings plan if your child decides to enroll in a private school or to attend college out of state.
Private college 529 plan: This type of account is a prepaid tuition plan for participating private colleges. If your child chooses to attend a school not in the plan, you could roll the account into a standard 529 plan.
If you’re unsure which plan may work best for your child, consult a financial advisor about your options.
How to Choose a 529 Plan
Now that you understand the types of 529s available, it’s time to consider which plan may work best for your child and their education. You may want to consider the following:
The type of risk exposure for the account
The timeline for your child’s education
The potential fees associated with each account you’re considering
Each plan’s history of returns and performance
Remember, you want to choose an account that offers investments within your risk tolerance levels. If something seems too risky or has a history of low performance, you may want to go with a different plan.
How to Open a 529 Plan
The easiest way to open a 529 plan is through your state’s Department of Higher Education. As part of the opening process, you need to select an owner and beneficiary for the account.
Whoever opens the account is the account owner. The beneficiary should be the future student.
Each account is limited to one owner and one beneficiary, meaning you need to open a separate 529 for each of your children. It also means that multiple people could set up a 529 account for the same beneficiary.9
If the beneficiary doesn’t use the full balance of the account or decides not to use the funds for education, the account owner may transfer the account to another beneficiary.
Once you select your beneficiary, and open the account, you may make your first contribution to the account. Keep in mind that your state may require you to pay a one-time setup fee. The exact amount depends on your location and your specific 529 plan.
How to Make Contributions
One of the top benefits of a 529 plan is that anyone, including friends and family, may contribute to the account at any time, even after the beneficiary turns 18 and starts college.
Contributions are usually made by check or through the plan’s online platform.10 Remember that these contributions are considered gifts, even if you’re contributing to your child’s account, meaning that amounts over the IRS’ estate and gift tax exemptions are subject to federal income taxes.11 As mentioned before, consult with a tax advisor on how these limits may apply to you.
Remember, while there are no annual contribution limits on 529s, there are total contribution maximums set by your state ranging from $235,000 to $500,000, depending on where you live.12
When making contributions, you may choose to add funds manually when you have money available. Or you may choose to make recurring deposits on a regular basis. Doing so may help maximize the account’s potential growth.
Investing Your 529 Plan
Every 529 plan is unique and offers different investment options. Most plans tend to break investment options down into three broad categories.
Age-based portfolios: Age-based portfolios use the beneficiary’s age when the account is opened to determine what investments are likely to offer the best returns before they need the funds. Oftentimes they start out with higher-risk investments since there’s more time to recoup any losses and gradually reduce risk as your child approaches college age.
Target risk portfolios: Target risk portfolios invest funds based on your risk tolerance, which you choose when you open the account. This tolerance is usually adjustable if you find yourself wanting to modify it later by working with the plan’s administrator.
Individual portfolios: These portfolios let you choose the types of investments the funds go toward based on the selection available through the plan’s administrator. These portfolios often allow you greater control over the plan’s investments and may include options such as mutual funds or EFTs.
Each investment option has its own risks. If you’re not sure which is the right fit for your needs, speak with a financial professional.
Withdrawing Funds From a 529 Plan
The purpose of 529 accounts is to help your student pay for education expenses. To this end, you could use the fund to cover costs like:13
Room and Board
Off-campus housing costs
Additionally, up to $10,000 may be used for tuition expenses at elementary or secondary schools.14
To withdraw funds, the account owner, usually the adult who opened the account, makes a request for withdrawal.
Once the request is made, the money is sent to either the school or a bank account. If you’re having funds deposited in your bank account, keep a record of every purchase you make with the 529 disbursement. By documenting your purchases, you may reduce your chances of being charged a penalty for using the money on a non-qualified expense.
If you end up using the money on expenses that aren’t approved under the IRS’s guidelines, you may have to pay a tax penalty. The exact penalty depends on the account’s investment performance and your current income tax bracket.
If you use the funds for a non-qualified expense, those earnings are also taxed as part of your annual income.
Is a 529 Account Right for Your Child?
Opening a 529 account may be a great way to build your child’s college fund and reduce the amount they may have to borrow for school. Before you open an account, make sure it’s the right fit for their needs.
You may ask yourself the following questions:
Do you believe your child plans to attend college?
Is your child young and several years away from attending college?
What is your risk tolerance?
If the answer is yes to the above questions, a 529 plan may make sense. But if you don’t think your child plans to go to school or they’re starting college in a few years and won’t benefit from the longer-term investment strategy 529 accounts offer, opening one may not be a good choice.
You also want to keep your risk tolerance in mind. Since 529 accounts are investment accounts, there’s always a risk that the account’s value may drop.
If you’re not sure if a 529 is the right choice for you, speak with a financial professional like your financial advisor or accountant.
Additionally, you want to contribute more to your child’s education fund, you may want to open an additional account, such as a high-yield savings account.
What Happens to a 529 Plan if My Child Doesn’t Go to College?
While the primary purpose of 529 funds is for education, the money isn’t lost if your child doesn’t go to college.
In this situation you have a few options.
Change the beneficiary: You may choose to transfer the account and its funds to another child, which may be a great choice for families with multiple children.
Roll into an IRA: You may roll up to $35,000 in a 529 account into a Roth IRA for the beneficiary. To be eligible, the 529 account must’ve been open for at least 15 years.15
These additional options may give you peace of mind about opening a 529 account if you want to take advantage of the benefits but aren’t certain about your child’s educational future.
529 accounts may help you save for your child’s higher education costs and set them up for less debt after graduation.
These accounts earn returns on their investments and help put your contributions to work month after month.
While 529s may be a great choice for saving for college, every situation is unique. Consult with a financial professional before you open one to ensure it’s the right choice for your family.