What is the 529 savings plan?

529s are the most popular college savings vehicle in the United States. There are currently over 14.83 million open 529 accounts, amounting to 424.2 billion in savings. On average, families save $28,679 in these accounts. Every broker and bank worth their salt competes to attract these dollars.

Named after section 529 of the internal revenue code, 529 plans offer tax-free savings growth and remain a compelling way for families to reduce their reliance on student loans.

Committing to a 529 increases the chances of your child pursuing higher education: children with a college savings account are 6 times more likely to attend a 4-year college, compared to those with no dedicated account.

How do 529 college savings plans work?

529 college saving plans are state-sponsored, but growth is subject to the specific investments of the plan. There are currently 49 state-sponsored 529 savings plans available.

“529 savings plans are investment accounts”, explains Bob Cole, President and CEO of Private College 529 Plan. “This means funds can benefit from market gains but are also subject to losses. The money saved in a college saving plan can cover various additional educational expenses, such as accommodation.”

529 incentives come in the form of tax-free earnings and withdrawals. Some state plans even offer matching contributions, i.e., they match a specified percentage of your contributions each year.

Other features of the 529 plan include:

• the account owner has control of the account, not the beneficiary
• the beneficiary can be changed at any time
• anyone can contribute to the account
• the account owner does not deal with the state but with the investment company who run the account
• the owner can move their investment into a different state plan based on performance. This can be done once every 12 months.

How to open a 529 plan

There are 2 options when opening a 529 college saving plan. The first, known as direct sold plans, is to manage your own investments, usually directly through the investment company’s trading platform.

“529 savings plans are investment accounts. This means funds can benefit from market gains but are also subject to losses. The money saved in a college saving plan can cover various additional educational expenses, such as accommodation.” – Bob Cole, President and CEO, Private College 529 Plan

Alternatively, you can enroll in an advisor-sold plan, meaning the investment firm manages the portfolio on your behalf.

Opening a 529 plan requires completing an online application through your state’s plan website or with a private broker. During the process, you will usually be asked to set up automatic contributions from your account. The minimum contribution is set at $15 to $25.

There are no annual contribution limits for 529 plans. However, any contribution over $16,000 needs to be reported to the IRS because it may no longer qualify for gift tax exclusion. There is also an aggregate contribution limit. This varies between state plans and can range from $235,000 to $550,000.

Generally speaking, 529s can be opened in any state plan – residency is not a criteria. Nevertheless, Cole suggests that families should first consider state tax benefits for their own state’s plan:

When opening a 529, try to start our with a college savings goal. Many families don’t save for the full cost of college, and with the availability of grants and scholarships, most don’t need to. Use a net price calculator to get a sense of your family’s aid eligibility before deciding how much you need to save.

529 plan tax benefits

The main draw of the 529 plan is the tax benefits. Most 529s offer some, or all, of the following:

1. Tax-deferred growth – The account is allowed to grow without federal or state income taxes. Over several years, the difference been taxed and untaxed growth can be huge.
2. Tax-free withdrawals – This only applies if you withdraw the money to pay for qualified educational expenses. These are subject to change, but currently include:
   • Tuition – this applies to college and vocational school, as well as up to $10,000 per year for K-12 expenses (in most states)
   • Study-related items – this includes buying textbooks, stationary, computers, and software
   • Accommodation – 529 savings can be used to cover room and board at college
   • Student loans – 529 savings can be used to pay off student loans, but be aware the lifetime limit of $10,000 cannot be exceeded
3. State tax deductions – In some states, contributions can be deducted from your taxable income
4. For tax purposes, contributions can be seen as gifts – The limit is $16,000 per individual per year. This accelerated gifting can reduce your personal tax estate
5. You do not have to report contributions on your federal tax return – This can simplify your tax return

To make the most of the 529 tax benefits, Cole emphasizes the importance of careful planning when using the funds:

3 tips to save more cash in your 529 plan

Most 529 plans offer simple tools for others to make gift contributions to your accounts. Take full advantage of these for birthdays and holidays.

Does a 529 plan affect federal aid?

If the account is in the parent’s name, the 529 has little impact on federal financial aid. 529 accounts are looked upon as parental assets, which means the impact on federal aid is less than if these assets were in the child’s name. Current federal aid regulations only consider 5.6% of parental assets and 20% of student assets.

To get a picture of how this works in practice, assume there are 2 families, each with an adjusted gross income (AGI) of $200,000.

• Family A saved $100,000 in their 529 account.
• Family B saved $0.
• Holding all other assumptions constant*, family A’s Expected Family Contribution (EFC) – which is a number colleges use to determine financial aid eligibility – will only be $5,420 more than Family B, even though Family A has a $100,000 college savings account.

*Assumptions using 2023-2023 Federal Methodology: for both families, we assume parent federal tax paid $30,000, student income $5,000, student assets $0, 4 household members, 1 in college, age of older parent 50, living in MA.

Note that if the 529 is under the name of another relative, for example a grandparent, it can reduce a student’s eligibility for financial aid by up to 50%. The table below shows how the owner of the plan can affect financial aid. All figures assume a sum of $50,000 in the account.

529 prepaid tuition and other alternative savings plans

A 529 prepaid tuition plan allows an individual to purchase tuition at today’s rates (sometimes with a discount) and redeem it in the future. The money can only be used to pay for tuition, not other expenses.

With a prepaid tuition plan you can pay with 1 up-front payment, sign up for a 5-year payment plan, or decide on fixed monthly payments.

These plans are limited to participating colleges, which tend to be public in-state schools. If a student eventually attends a non-participating college, they may lose the benefits this plan provides.

The advantage of prepaid tuition plans is that they offer a pretty certain hedge against the rising costs of tuition. A disadvantage is that they are currently only offered by 9 states:

• Florida
• Maryland
• Massachusetts
• Michigan
• Mississippi
• Nevada
• Pennsylvania
• Texas
• Washington

Most prepaid plans are created for the public colleges in their state and have residency requirements. However, those who don’t qualify can consider Private College 529, which allows you to lock in tuition rates at hundreds of colleges nationwide.

Jump to our interview with Bob Cole for more information on the Private College 529 plan.

When deciding between a college savings plan and a prepaid tuition plan, Cole suggests parents don’t need to limit themselves to one or the other:

Coverdell ESA

The Coverdell education savings account (ESA) is an alternative to the 529 and offers similar tax breaks.

Previously, an advantage the ESA had over the 529 was that savings could be used for K-12 education. The 529 now also offers that benefit, making the ESA less popular. According to the latest figures, there are still $7 billion of Coverdell ESA assets currently invested in mutual funds.

Coverdell ESA vs 529

The table below outlines some of the differences between the Coverdell ESA and 529 plan.

Roth IRA

The Roth Individual Retirement Account (IRA) is typically used to save for retirement, but can also be used to save for college. Like the 529, Roth IRA also offers tax-free growth on savings. However, there are significant differences between the 2 plans:

• The annual ROTH IRA contribution limit is much lower than in the 529 plan
• Roth IRA contributions are ineligible for state income tax deduction
• Roth IRA withdrawals count as income on financial aid forms, which can have a significant effect on how much aid is offered

Roth IRAs are becoming a more popular option to save for college because, like 529 plans, contributions are after tax and earnings grow tax-free.

“There is no early withdrawal penalty if the funds are used for educational expenses,” Cole explains. “Roth IRAs offer a lot of flexibility for using the funds. The downside? There are annual contribution limits ($6,000 or $7,000) and income phaseouts start at $129,000 (single filers) and $204,000 (married, filing jointly).”

UGMA/UTMA

The Uniform Gift to Minors Act (UGMA) account and Uniform Transfer to Minors Act (UTMA) account are custodial trusts that parents can set up for their children. The main difference is that the money already belongs to the child and cannot be withdrawn until a certain age.

These accounts offer far greater flexibility than the 529 when it comes to using the funds. For example, the beneficiary might not go to college at all, and use it for an apprenticeship or business venture. Custodial trusts also give greater responsibility to the beneficiary, which may appeal to some parents.

A significant disadvantage is that the trusts count as student assets and have more of an impact on financial aid than a 529 in their parent’s name. Therefore, Cole believes the 529 remains the best choice for funding education:

How to choose a 529 plan

First, decide between a pre-paid tuition plan or college savings plan. Most choose one of the 49 state-sponsored college savings plans. You’ll then need to decide between the direct-sold and advisor-sold option. Those with little investment experience tend to choose advisor-sold because the portfolio is managed for them.

Once you’ve decided to commit to a 529, research the specific plans on offer. Always consider your home-state 529 plan first, as residents may be eligible for additional benefits and tax breaks.

Another important aspect is the minimum contribution amount. We all want to save as much money as we can for our children’s education, but a 529 is a long-term commitment, and you need to be able to comfortably make the monthly payments.