529 Plans: How They Work and When to Use Them

If you’re thinking about saving for your child’s college education, you’ve probably heard of 529 plans.

They’ve been the go-to college savings account for a while now, and with the recent changes to our tax code they’ve become even more flexible. That’s because the tax breaks offered by 529 plans have been expanded to include K-12 expenses in addition to higher education expenses.

But there’s a lot of confusion around 529 plans and when it makes sense to use them, and this post will clear that up. You’ll learn what 529 plans are, how they work, and what the pros and cons are.

Let’s get into it!

What Are 529 Plans?

A 529 plan is simply an investment account that offers tax breaks when the money is used for qualified education expenses like tuition, fees, books and other supplies, and room and board. In fact, they function much like a Roth IRA, but for education instead of retirement.

Contributions to a 529 plan are made after-tax, though some states allow you to deduct your contributions for state income tax purposes. Money inside a 529 plan grows tax-free, and money can be withdrawn tax-free for qualified education expenses. If it’s withdrawn for any other purpose, the earnings are subject to taxes and a 10% penalty.

Until December, qualified education expenses only included higher education. But with the passing of the Tax Cuts and Jobs Act, you can now withdraw up to $10,000 per year, per child, tax-free for qualified K-12 expenses as well.

Which means that 529 plans have become tax-advantaged education savings accounts instead of being limited to college savings like they were previously.

529 plans are run by states with almost every state offering one or more options. There are two main types of 529 plans, each of which has its own pros and cons.

529 savings plans allow you to invest your contributions in a pre-selected set of mutual funds, similar to how you’re offered a set of investment options within your 401(k). Your account balance rises and falls based on your contributions and the performance of your investments, and the money you have in your account can be used at any time for any qualified education expenses.

Although 529 savings plans are run by states, you’re not obligated to use your home state’s plan. In fact, you may save money by using another state’s plan, which we’ll get into below.

529 prepaid tuition plans allow you to pre-purchase college credits at public in-state universities, essentially allowing you to lock in the current cost of college. They’re not as flexible as 529 savings plans, which can be used for any qualified expense incurred at any eligible school across the country – but they do offer a little more certainty in the sense that you know exactly how much school credit you’re purchasing.

For the most part, you must be a state resident to enroll in a particular state’s prepaid tuition plan.

While 529 prepaid tuition plans can be useful in the right situations, they can also be fairly restrictive, and the terms and conditions vary by state.

529 savings plans are more flexible, more widely available, and generally make more sense for most families. For those reasons, the rest of this article will focus specifically on 529 savings plans.

Pros of 529 Savings Plans

1. Tax-Free Growth and Withdrawals

The tax benefits are the big draw of 529 plans. The money you invest grows tax-free and can be withdrawn tax-free for education expenses, which means that every dollar you save goes further than it would in a regular investment account.

Let’s say that you can afford to invest $1,000 per year from the day your child is born and that you earn an 8% annual return. Two percent of that annual growth is in the form of dividends taxed at 15% per year, and the rest of that growth is from capital gains that are taxed at 15% when you sell.

After 18 years, you would end up with approximately $36,999 after taxes in a regular taxable investment account. But you would have $41,446 in a 529 plan, because all of the growth would be tax-free.

Those tax breaks translate to an extra $4,447 available for education expenses.

2. State Income Tax Deductions

While you can’t deduct your 529 plan contributions for federal income tax purposes, there are currently more than 30 states that offer a state income tax deduction, and in some cases you don’t even have to contribute to your home state’s plan in order to get it.

If you live in one of those states, that deduction could allow you to contribute a little bit more because of the tax savings you receive on the back end.

3. High Contribution Limits

Unlike Roth IRAs, 529 plans have no income restrictions that prevent people from contributing, and very little in the way of contribution limits.

Most 529 plans have lifetime contribution limits that range from $235,000 to $500,000, but most of them do not have annual contribution limits. Though for the most part annual contributions from any individual are effectively limited to $15,000 per year, per child, due to the federal gift tax.

Married couples filing jointly can combine that limit and contribute up to $30,000 per year, per child, and there’s even a way to contribute five times that amount in a single year without gift tax consequences.

The bottom line is that if you want to save a lot of money for education, a 529 plan will allow you to do it.

4. Flexibility to Change Beneficiaries

Each 529 plan has a named beneficiary, which is the person that the money is being saved for. But you can change the beneficiary to just about any other family member, which means that if one child doesn’t need all the money for education you can simply use it for another child, or even for yourself or a grandchild or a niece or nephew.

Cons of 529 Savings Plans

1. Limited to Education Expenses

The big downside to 529 plans is that if you don’t use the money for qualified education expenses, the earnings you withdraw are both taxed and subject to a 10% penalty.

There are exceptions for scholarships, but beyond that, those penalties should make you wary about over-contributing to a 529 plan.

2. Potential State Penalties When Used for K-12 Expenses

While the federal law has been updated to allow tax-free and penalty-free withdrawals for qualified K-12 expenses, some states may not be quite as generous.

There are concerns that some states might still apply penalties for withdrawals that aren’t used for higher education and may also recapture any state income tax deductions from prior years for early withdrawals. Given how new all of this is, it’s probably a good idea to speak to an accountant before using 529 money for K-12 expenses.

3. Potentially Costly Investments

Each 529 plan offers its own limited set of investment options, and in some cases those investment options can be quite costly.

For example, Montana’s 529 plan offers several investment portfolios that each cost around 0.80% per year, compared to New York’s 529 plan where every investment option costs 0.15% per year.

Cost is the best predictor of future returns, with lower costs leading to better performance. If your state’s investment options are high-cost, you’ll have to weigh the savings offered elsewhere against any potential state income tax deduction before deciding which plan to use.

4. Don’t Forget About Other Financial Goals

While saving for your child’s education is great, it’s usually a good idea to prioritize other financial goals first. Contributing to a 529 plan typically only makes sense once you’ve already handled other financial responsibilities like saving for retirement, getting insurance, and paying off debt.

529 Plans the Smart Way

529 plans can be a great way to save ahead for your child’s education, especially now that the money can be used for K-12 expenses as well. That added flexibility simply increases the opportunities you’ll have to use the money for whatever you need.

But the fact that withdrawals from a 529 plan are taxed and penalized if they’re not used for qualified education expenses means that you should contribute carefully. You don’t want to contribute money that might be needed for other financial priorities, and you don’t want to over-contribute and have more saved up than you actually end up needing.

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.

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