529 College Savings Plans: Everything You Need to Know

What is a 529 College Savings Plan?

A 529 Savings Plan is an investment account offering tax and financial aid benefits for students. Your money grows tax-free so long as you use it for qualified educational expenses. This includes higher education costs at more than 6,000 U.S. colleges and more than 400 foreign colleges—tuition, fees, books, supplies, equipment, computers, and potentially room and board. 529 Savings Plans can also be used to pay up to $10,000 of K-12 tuition per year.

All states, except for Wyoming, offer a 529 Savings Plan. You’re welcome to enroll in a 529 Savings Plan from any state regardless of your residency or chosen college. For example, if you live in Pennsylvania, you could enroll in California’s 529 Savings Plan to cover college costs in New Jersey. However, investing in your home state’s plan could qualify you for state income tax deductions.

How Does a 529 College Savings Plan Work?

A 529 College Savings Plan works like your typical investment account except you don’t pay taxes on earnings when you withdraw money for qualifying educational purposes. You contribute what you want when you want. Many users choose to set up automated monthly deposits from a bank account to keep contributions consistent. Others prefer lump sum payments around the holidays or birthdays.

You choose what funds you want to invest in based on the options offered by your provider. Any earnings get reinvested, maximizing growth potential. When it’s time to make a withdrawal, you can set up a direct payment to the qualifying educational institution, the beneficiary, or another eligible entity. Funds withdrawn for a qualifying educational expense are federal tax-free.

What if I Withdraw Funds for Another Use?

If you withdraw funds for a use other than a qualifying educational expense, you’re subject to paying income tax on the earnings and a penalty. However, you can have the penalty waived if the beneficiary:

  • Earns a tax-free scholarship
  • Attends a U.S. Military Academy
  • Dies or becomes disabled.

What if My Child Decides Not to Attend College?

If your beneficiary decides not to attend college and you’re hoping to avoid income tax and penalties, you have a few options:

  • Change the beneficiary to another qualifying family member
  • Keep the funds in the account in case the beneficiary decides to attend college or grad school in the future
  • Rename yourself as the beneficiary to further your education
  • Move funds to a 529 ABLE account if your beneficiary is diagnosed with a disability
  • Withdraw funds with earnings subject to federal income tax and a 10% penalty

How Does a 529 College Savings Account Affect Financial Aid?

When you save for college, you need to be strategic. Save too much and your child could miss out on need-based scholarships and grants. Save too little and your child might need to borrow student loans.

The way 529 plans affect financial aid varies between institutions, but in general, what matters most is who sets up the plan.

Dependent Student or Dependent Student Custodial Parent

If a dependent student or a dependent student’s custodial parent owns the account, it is reported as a parent asset on the FAFSA. It is not reported as income. At most, this reduces the student’s eligibility for need-based aid by up to 5.64% of the unsheltered net asset value.

Independent Student

If an independent student owns the account, it is reported as a student asset on the FAFSA. It is not reported as income. This will reduce need-based financial aid eligibility by 20% of the net asset value. Find out if you’re a dependent or independent student here.

All Other

If a grandparent, non-custodial parent, or anyone else other than those listed above owns the account, it is not reported as an asset on the FAFSA. However, it is reported as untaxed income for the student on the FAFSA. This can have a big impact on the student’s eligibility for need-based financial aid.

Advantages of a 529 College Savings Plan

529 College Savings Plans let you save for your child’s future education tax-free. These plans offer several other benefits, especially when comparing against other college saving alternatives.

With a 529 College Savings Plan:

  • You can enroll your child (or yourself) at any age or grade
  • Any U.S. resident can enroll
  • You contribute what you can when you can
  • Funds can be used to cover qualified K-12 expenses and/or higher education tuition, fees, housing, books, and supplies at any qualified public or private institution
  • You can transfer the funds to another beneficiary (including yourself) if desired
  • Contributions grow federal tax-free when used to pay for qualifying education expenses
  • Some states offer state income tax breaks for 529 plans
  • No income limits, age limits, or annual contribution limits like you’d find with Roth IRAS and Coverdell Education Savings Accounts
  • You can open more than one account for a single beneficiary

Disadvantages of a 529 College Savings Plan

Of course, a 529 College Savings Plan has a few drawbacks worth considering:

  • High risk because your money isn’t guaranteed like it is with a prepaid college savings plan
  • You must pay income tax and a 10% penalty on all unqualified withdrawals
  • Lifetime contribution limits range from $235,000 to $520,000
  • Withdrawn funds could disqualify your student from receiving need-based financial aid on the FAFSA and CSS Profile
  • What counts as a qualified distribution is strict

Alternatives to 529 Savings Plans

A 529 Savings Plan isn’t for everyone. Other college savings options like Prepaid Plans, high-yield savings accounts, or Roth IRA accounts might better fit your needs.

529 Prepaid Plan

Along with offering a 529 College Savings Plan, a few states also offer Prepaid Tuition Plans. A prepaid plan lets you prepay for your child’s education based on locked-in anticipated tuition rates. Your money is guaranteed, so you never lose the value that you put into the account. This isn’t the case with 529 College Savings Plans. Plus, even if tuition rates increase more than expected by the time your child enrolls, a fully funded prepaid college plan still covers the cost.

Many families pair a prepaid plan with a 529 college savings plan. The first is used for tuition costs and sometimes room and board. The second helps cover the cost of books and supplies.

Learn more about prepaid plans here.

Roth IRA

With a tax-advantaged Roth IRA account, you can save for your retirement and your child’s education simultaneously. Any money you withdraw to cover educational expenses is penalty-free. Additionally, if your child opts not to go to college, you can keep funds in the account for your retirement.

Roth IRAs have annual contribution limits of $6,000 depending on your age. Pairing a Roth IRA with another saving method can ensure you have enough for retirement and your child’s education.

High-Yield Savings Account

Use a high-yield savings account if you want a low-risk, flexible way to save for college. High-yield savings accounts offer 1.8% or higher APY and keep your money easily accessible. That accessibility is great if your child decides not to attend college or you face economic struggles. However, because it’s easily accessible, it can be tempting to spend your savings frivolously.

Get Started with a 529 College Savings Plan

Anyone can open a 529 College Savings Plan, and it’s easy to do! Follow the steps below to get started:

Decide Who Will Open the Account

Remember, who owns the account matters and could significantly affect financial aid. Before opening an account, make sure you fully understand how this decision could help or hurt your student’s shot at need-based financial aid. Talk to an accountant to learn more about the tax implications in your state too.

Choose a Provider

At the end of the article, you’ll see a list of 529 College Savings Plan providers. Look at your state’s plan first to see if it offers tax benefits. If it does, your state’s plan is likely your best option. If it doesn’t, explore other state plans. You can enroll in any state’s plan regardless of your residency status or where your child decides to go to college.

Choose an Investment Fund/Portfolio

Each plan offers different investment fund or portfolio options. For example, in Pennsylvania, you can choose between a low-risk guaranteed savings plan and an investment plan. The guaranteed savings plan helps your savings to keep up with rising tuition costs. The investment plan lets you choose from 17 investment options from The Vanguard Group.

Start Making Contributions

Some funds require a minimum contribution when you open the account. The amount ranges from $0 to $250.

After paying the minimum contribution, consider the additional contribution options. Most plans let you set up automatic payroll deduction, make lump sum payments, and rollover remaining funds from a different 529 plan, a Coverdell Education Savings Account, or a U.S. Savings Bond.

List of States Offering 529 College Savings Plans

Compare plans across different states to see what makes sense for your family. Your home state may offer state tax benefits, which may only be available if you invest in your home state’s plan.

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