With some help from Travis Sickle of Sickle Hunter Financial Advisors in Tampa, FL. A great resource for a plethora of financial information!

A 529 plan is an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary. You can use a 529 plan to pay for college, K-12 tuition, apprenticeship programs, and student loan repayments. If using a 529 plan to save for college, your savings will have a minimal impact on financial aid eligibility.

Types of 529 Plans

529 plans are usually categorized as either pre-paid tuition or college savings plans.

College savings plans  work much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds or similar investments. The 529 college savings plan offers several investment options from which to choose. The 529 plan account will go up or down in value based on the performance of the investment options. You can see how each 529 plan’s investment options are performing by reviewing our quarterly 529 plan performance rankings.

Pre-paid tuition plans  let you pre-pay all or part of the costs of an in-state public college education. Your funds may also convert for use at private and out-of-state colleges. The Private College 529 Plan is a separate pre-paid plan for private colleges sponsored by more than 250 private colleges.

Educational institutions can offer a pre-paid tuition plan but not a college savings plan. The first education savings plan was a pre-paid tuition plan: the Michigan Education Trust (MET) was created in 1986. More than a decade later, Section 529 was added to the Internal Revenue Code, authorizing tax-free status for qualified tuition programs. Today, over 100 different 529 plans are available to suit various education savings needs.

529 Plan Tax Benefits

A 529 college savings plan works much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds, ETFs, and other similar investments. Contributions are not deductible from federal income taxes. Your investment grows tax-deferred and can be withdrawn tax-free if the money is used to pay for qualified higher education expenses. 

Depending on where you live, you may also qualify for a state tax benefit. More than 30 states offer state income tax deductions and state tax credits for 529 plan contributions. These tax benefits make 529 plans better for college savings accounts than traditional savings or investment accounts.

Some families use 529 plans as an estate planning vehicle since contributions are considered completed gifts to the beneficiary. Up to $16,000 per donor per beneficiary qualifies for the annual gift tax exclusion. 

How to Choose a 529 Plan 

Nearly every state has at least one 529 plan available, but you’re not limited to using your home state’s program. Each 529 plan offers investment portfolios tailored to the account owner’s risk tolerance and time horizon. Your account may go up or down in value based on the performance of the investment option you select. It’s essential to consider your investment objectives and compare your options before you invest. 

How Much Can I Contribute?

There are no annual 529 plan contribution limits. However, some critical things to consider when making a significant contribution. For example, contributions over the annual gift tax exclusion ($16,000 in 2022) will count against your lifetime estate and gift tax exemption ($12.06 million in 2022). 

Each state also has an aggregate contribution limit for 529 plans, which ranges from $235,000 to $550,000. This amount is based on the price of attending an expensive college and graduate school program, including textbooks and room and board.   

As a rule of thumb, you can aim to save about one-third of your projected future college costs. This assumes you can cover the remaining two-thirds with your current income, including scholarship funds and student loans. 

What happens if I can’t afford the monthly payments?

Most plans allow you to set up automatic recurring deposits from a linked bank account, but it’s not required. After you make a minimum initial contribution requirement (sometimes as low as $25), you can invest as much as you want, whenever you want. 

You may make lump sum contributions around birthdays, holidays, or other occasions. 529 plans also accept gift contributions from family, friends, and other loved ones. 

Will Having a 529 Plan Affect Financial Aid?

When a dependent student or one of their parents owns a 529 plan account, there is a minimal impact on the student’s financial aid eligibility compared to other savings accounts, such as a UGMA/UTMA account. Assets held in the 529 plan receive favorable treatment on the Free Application for Federal Student Aid (FAFSA), and distributions are not reported. 

However, aid eligibility may have a more significant impact when a grandparent or other third party owns the 529 account. In this case, assets are not reported, but distributions used to pay for college are considered cash support to the student. This can reduce the student’s eligibility for need-based aid by as much as 50% of the distribution amount. 

What are Qualified Education Expenses? 

Remember, only qualified withdrawals are tax-free. You should only use your 529 plan to pay for qualified educational expenses. 529 plan withdrawals must happen in the same tax year as the expenses

Qualified expenses for college include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access, and special needs equipment for students attending a college, university, or other eligible post-secondary educational institutions. 

However, there are some costs that you may believe are necessary, but the IRS does not consider a qualified expense. For example, a student’s health insurance and transportation costs are not qualified expenses unless the college charges them as part of a comprehensive tuition fee or is identified as a fee “required for enrollment or attendance” at the college.

In recent years, the IRS has expanded the definition of qualified education expenses beyond traditional college costs to include K-12 tuition expenses and student loan repayments. There is a $10,000 annual limit on qualified K-12 withdrawals and a $10,000 lifetime limit on student loans. Another option is to use the savings plan for registered apprenticeship program expenses.

The funds in a 529 plan are yours, and you can always withdraw them for any purpose. However, the earnings portion of a non-qualified distribution will be subject to ordinary income taxes and a 10% tax penalty, though there are exceptions.

Can I use a 529 plan to pay for rent?

Yes, room and board are considered a qualified expense if the student is enrolled at least half-time, which most colleges and universities consider to be at least six credit hours per term.

For on-campus residents, qualified room-and-board expenses cannot exceed the amount charged by the college for room and board. For students living off-campus, qualified room and board expenses are limited to the college’s cost of attendance figures. Contact your financial aid office for more information.

How to Withdraw from a 529 Plan

You can use your education savings to pay for college costs at any eligible institution, including more than 6,000 U.S. colleges and universities and more than 400 international schools. For example, you can be a California resident, invest in a Vermont plan, and send your student to college in North Carolina. 

Once you’re ready to start withdrawing from a 529 plan, most plans allow you to distribute the payments directly to the account holder, the beneficiary, or the school. Some plans may allow you to make a payment directly from your 529 account to another third party, such as a landlord.

Remember, you will need to check with your plan to learn more about how to take distributions from your account. Depending on your circumstances, you may need to report contributions to or withdrawals from your 529 plan on your annual tax returns.

What Happens if My Child Doesn’t Go to College?

The future is always uncertain, and some parents worry about losing the funds they saved in a 529 plan if their child doesn’t attend college or gets a scholarship. Generally, you will pay income tax and a penalty on the earnings portion of a non-qualified withdrawal, but there are some exceptions. The penalty is waived if:

However, the earnings portion of the withdrawal will be subject to federal income tax and sometimes state income tax.

What happens to money not used in a 529 plan?

If you have leftover money in your 529 plan and you want to avoid paying taxes and a penalty on your earnings, you have a few options, including:

Remember, you can withdraw leftover funds in a 529 plan for any reason. However, the earnings portion of a non-qualified withdrawal will be subject to taxes and a penalty unless you qualify for one of the exceptions listed above. If you are contemplating a non-qualified distribution, be aware of the rules and possible tactics for reducing taxes owed.

Can you lose money in a 529 savings plan?

While you will not lose unused funds, it is essential to note that most 529 plan investment options entail market risk and invest in equities and bonds. For risk-averse investors, many 529 plans offer FDIC-insured account options or ‘stable value’ portfolios, which provide lower risk but also lower returns.

How to Open a 529 Plan 

Opening a college savings plan is easy. You can open a direct sold 529 plan by completing an application on the plan’s website. Direct-sold plans offer lower fees than advisor-sold plans, but the account owner is responsible for selecting the investments. Advisor-sold 529 plans are only available through licensed financial advisors. 

Who Can Open a 529 Plan

One of the advantages of 529 plans is that just about anyone can open one. Parents, grandparents, friends, and even students themselves (if they are 18 years old) can open a 529 college savings plan to start a college fund.