What is a 529 plan?
Editorial staff, J.P. Morgan Wealth Management
- A 529 plan is a tax-free investment account specifically for qualified education expenses.
- A 529 plan is a popular choice for many parents saving up for their kids’ education. Qualified education expenses include college tuition, room and board, textbooks, computers, vocational school, apprenticeship programs, certain career training and certifications, K-12 tuition and certain student loan repayments. (Note: Not all states use the federal definition of a qualified education expense and some exclude anything other than college or vocational school expenses.)
- Earnings withdrawn for non-qualified expenses are subject to a 10% penalty and ordinary income taxes. There is no penalty on the principal.
- Up to $35,000 can be rolled over tax-free into a Roth IRA for the 529 account beneficiary, though certain conditions apply.
A 529 plan can be a useful tool to help save for college. It may be especially well-suited for parents with young kids since the money has ample time to grow, but it can still be beneficial for teenagers or even adults planning to go to college.
Let’s look at the specifics of a 529 plan – including contribution and withdrawal rules – so you can decide if it’s right for you.
529 plan: What to know
A 529 plan is an investment account that offers tax-deferred earnings growth and tax-free withdrawals when the funds are used to pay for a designated beneficiary’s qualified education expenses. Anyone planning on college or other paid education can open one, but it’s popular with parents who are planning for their kids’ college.
The major benefits of a 529 plan include:
- The account offers tax-deferred earnings growth and tax-free withdrawal for qualified education expenses.
- Some states offer tax deductions or credits on 529 plan contributions.
- 529 plans are not just for college. The money invested can also be used to pay for K-12 tuition, vocational school and apprenticeship programs and certain student loan repayments. The recently passed One Big Beautiful Bill Act also expanded 529 coverage to include qualified postsecondary credential programs and additional K-12 fees other than just tuition, such as books, tutoring, test fees and more. (Note: Not all states use the federal definition of a qualified education expense and some exclude anything other than college or vocational school expenses.)
529 plan example
Let’s take a quick look at a simplified hypothetical example: Suppose you’ve just had a baby and decide to start a 529 plan for their college expenses. Let’s further assume you make an initial deposit of $5,000 and you’ll deposit another $100 into the account monthly without fail until your child turns 18. Finally, let’s say that the account offers a 5% annual return rate, compounded yearly.
After the full 18 years, the total of your deposit plus monthly contributions comes out to $21,600 – that’s without interest. When you factor in the annually compounding interest rate of 5%, the final account balance could grow to a little under $46,000. Note that this is a simplified example that assumes you’re contributing the same amount consistently and doesn’t account for things like costs and fees.
529 plan costs and fees
There may be various fees associated with 529 plans, including administrative fees, expense ratios and account maintenance fees. Since fees can chip away at your money over time, it helps to ensure that you're aware of and comfortable with every fee you're paying. That said, remember that "no fee" or "low fee" is just one of several considerations to weigh when making a decision. You may also want to consider performance and flexibility to see how a 529 plan aligns with your goals. Also, many state plans offer a tax deduction or credit to in-state residents on contributions, so you might want to check your state’s 529 plans first.
The good news is that most 529 plan websites offer details on their plans’ performance history, investment options and fees, simplifying the research process.
Who can contribute to a 529 plan?
Just about anyone over the age of 18 can open and contribute to a 529 plan.
Although it’s more common for parents or grandparents to open a 529 plan for their loved ones, it’s also possible for an adult with college plans to open one for themselves. If you find yourself with no education savings yet and plan on attending college or some other qualifying education program, it may make more sense to invest in a tax-advantaged 529 savings account than contribute to a general savings account.
Even if you’re already a student, opening a 529 account may be advantageous due to the potential state tax benefits. If your state’s 529 plan offers tax breaks on contributions made by in-state residents, you may benefit from depositing into the plan and then using the funds to pay qualified educational expenses to receive the tax benefit. Be sure to research your state’s tax laws or speak with an advisor beforehand to ensure there is a deduction to claim.
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How does a 529 plan work?
There are two major types of 529 plans. The first is a savings plan, where you invest money for future education-related expenses. The second is a prepaid tuition plan, where you purchase some or all of the tuition from an in-state school.
Savings plan
Under a savings plan, you get to choose from a selection of investment portfolios offered by the plan. One potential option is an age-based or target-date fund, where your investments automatically adjust and become more conservative as the beneficiary gets closer to withdrawing funds. Savings plans don’t guarantee a certain payout but offer a lot of flexibility with school/program choice and cover a variety of education expenses.
Prepaid tuition plan
Prepaid tuition plans are less flexible but may provide additional protection against tuition inflation. With these plans, you essentially pre-purchase an in-state college’s tuition and fees at today’s prices in the form of tuition credits (not to be confused with the academic credits a student needs to graduate). These tuition credits are then invested by the plan’s administrator to hopefully match inflation over the years. Depending on the plan, school or state, you may even get some money back when your child enrolls if those investments significantly outpaced inflation (with no penalty to you if they don’t).
A prepaid tuition plan may be smart if your child will be attending a qualifying in-state school and you want to purchase tuition credits at their current cost, not what the cost may be 10-plus years down the road. However, it doesn't cover room and board expenses and also limits your school choice.
Designating beneficiaries
529 plans generally offer a great deal of flexibility regarding beneficiaries, so you can name just about anyone with a valid U.S. Social Security or taxpayer identification number – your children, a relative, a friend or even yourself. Note that some plans may also have state-specific restrictions to be aware of such as being limited to in-state residents only.
You may also change your beneficiary at any time. It’s worth noting, however, that depending on how this is done, it may have potential tax consequences or affect financial aid (more on this later).
Withdrawal rules
Unlike retirement plans, withdrawals from a 529 plan can happen at any age. However, there are some strict rules around them.
Non-qualified withdrawals are subject to federal income tax and a 10% penalty on the earnings portion of the distribution. The principal portion of the 529 withdrawal is not subject to tax or penalty. Certain states may assess a penalty, possibly taking back the state's tax breaks on the original contribution. Exceptions to the penalty include when the beneficiary dies, becomes disabled, attends a U.S. Military Academy or earns a scholarship.
Withdrawal rules and restrictions still apply if the beneficiary decides not to go to college – however, there are other education expenses beyond college that are covered by a 529 plan.
What does a 529 plan cover?
Although 529 plans have stringent withdrawal rules, the good news is that a lot of expenses fall under the umbrella of “qualifying education expenses.” These include:
- College tuition and fees (international schools typically qualify too)
- Room and board
- Textbooks
- Computer
- Other necessary school equipment (like a printer)
- Private or religious K-12 tuition and additional fees (like books, tutoring, tests, etc.)
- Registered apprenticeship programs or vocational schools
- Certain student loan repayments
- Qualified postsecondary credential programs
- Rollover up to $35,000 lifetime limit into a Roth IRA for the 529 account beneficiary – up to the annual contribution limits for a Roth IRA, account must be open at least 15 years, contributions made during the prior five years are not eligible for rollover
- Additionally, if the beneficiary receives a tax-free scholarship or grant, they can withdraw the same amount from the plan
Does a 529 plan affect financial aid?
In short, yes – a 529 plan can affect financial aid for students.
The plan is counted as either an asset or income on the Free Application for Federal Student Aid (FAFSA) form, which impacts how much financial aid the student qualifies for. However, with advance planning, this impact can be minimized.
Strategies to get the most from financial aid while having a 529 plan include:
- Designating a parent as the plan owner (if possible): Although the plan will still have to be listed as an asset on the FAFSA, a parent’s assets have less impact than a student’s assets, since parents are expected to contribute a smaller portion. If the 529 plan is already owned by the student or another person, most states allow change in ownership.
- Considering some student loans: Federal loans are preferable as they tend to have lower interest rates. A 529 plan can be used post-graduation to cover up to $10,000 in qualifying student loan payments.
- Applying for scholarships or grants: A 529 plan has no bearing on these.
How to open a 529 plan
Although specifics may vary based on your situation, opening a 529 plan generally involves the following steps:
- Do your research: You’ll want to do some research into what plan type best suits you, whether it’s a college savings plan or a prepaid tuition plan.
- Explore available options: Once you’ve picked a plan type, it’s time to explore your available options. This could include in-state or out-of-state options, as well as direct-sold plans versus advisor-sold plans. Direct-sold plans usually have lower costs but do not provide advice. Advisor-sold plans typically have higher costs but include access to an advisor.
- Examine tax benefits: Many state plans offer a tax deduction or credit to in-state residents on contributions, so you might want to check your state’s 529 plans first.
- Select and apply for your preferred plan: Once you’ve narrowed down your options, it’s time to fill out the application forms and make things official.
- Determine your initial contribution: Most 529 plans have a low minimum initial contribution, which may be waived in some cases if you set up recurring contributions.
- Fund your account and start saving: Now it’s time to add your funds to the account and, if you choose to do so, start making your recurring contributions.
The bottom line
The 529 plan is the preferred funding method for many parents. The account’s popularity is partly due to its tax advantages, and, in the current environment especially, its flexibility. With regular contributions and time to grow, a 529 plan can help make a sizable dent in paying K-12, college, vocational school or other postsecondary program expenses like tuition, room and board, textbooks and more.
Frequently asked questions about 529 plans
There are no federal limits to how much you can contribute to a 529 plan, although contributions are subject to gift tax if they exceed the annual exclusion limit. The most up-to-date annual exclusion for gift tax can be found on the IRS website. Some states may also have their own maximum contribution limits.
To set up a 529 plan, you’ll first need to select the type of plan – savings or prepaid. After this selection, you’ll need to name your beneficiary and fill out the required paperwork with the plan’s provider. Once your application is approved and the account is open, you can start contributing to it.
529 plans cover a variety of educational expenses. Examples of qualified expenses include tuition, room and board, textbooks, computer equipment and possibly even some student loan repayments. The IRS sets the guidelines for qualified expenses for federal tax purposes, while each state’s tax authority makes the determinations at a state level. You may want to consult with a tax professional to confirm what is considered a qualified expense in your state.
Generally, there is no limit to how many 529 plans a child can have. However, there may be additional restricting factors such as your state’s aggregate contribution limits. You also can’t open two plans of the same type in the same state for the same beneficiary. For example, you can open a college savings plan for your child in State A and State B, or a college savings plan and a prepaid plan in State A, but not two college savings plans in State A. However, another account owner (example: a grandparent) can open a 529 account in the same state for the same beneficiary.
Let’s say your 529 plan goes unused, possibly because your beneficiary did not attend college or vocational school. In this case, you have the following options:
- Change your beneficiary to someone else
- Roll over up to $35,000 to a Roth IRA for the beneficiary – this is a newer option that’s subject to specific stipulations, so consult with a qualified financial advisor to learn more
- Roll over to ABLE accounts
- Withdraw the funds but face the associated penalties of an unqualified withdrawal
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Editorial staff, J.P. Morgan Wealth Management
