What Is a 529 Plan?
A 529 plan is a tax-advantaged vehicle designed to encourage saving for future educational expenses. Available nationwide, these plans allow for tax-exempt growth of your savings. However, to capture this benefit, you must comply with pertinent guidelines.
- Written By Thomas J. Brock, CFA®, CPA
Thomas J. Brock, CFA®, CPA
Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.Read More
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- Updated: January 30, 2023
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529 Plan Definition
A 529 plan is a financial account that helps people save for future educational expenses. Authorized by Section 529 of the Internal Revenue Code, it offers tax-exempt growth of your savings.
- Contributions are made on an after-tax basis. No tax deductions or credits are permitted at the federal level, but, in some situations, deductions or credits exist at the state level.
- The contributions are invested and allowed to grow free of federal income tax and state income tax in most cases, which can have a powerful compounding effect over time.
- Typically, no federal income taxes and no state income taxes are ever imposed as you withdraw the contributions and the accumulated earnings — as long as you use the money for qualified expenses.
Types of 529 Plans
The 529 plans, which are often referred to as qualified tuition plans, are sponsored broadly by states, state agencies and educational institutions. However, there are only two different types of 529 plans — education savings plans and prepaid tuition plans.
Education Savings Plan
An education savings plan allows you to open an investment account to save for a beneficiary’s future educational expenses. Most plans are used to pay for qualified education expenses associated with colleges and universities, such as tuition, mandatory fees, as well as room and board. However, plans can also be used to pay up to $10,000 for tuition per year per beneficiary at any public or private elementary or secondary school.
Investment options are usually limited, but broad enough to cater to your risk-return profile. Generally, the investment selections consist of any range of mutual funds, exchange-traded funds (ETFs) and principal-protected bank products. Many also offer target-date funds, which give you the ability to select a custom fund based on your planned spending date. Once selected, the administration of your investments becomes automatic, and your exposure gradually becomes more conservative as the spending date nears.
All education savings plans are sponsored by state governments but only a few have in-state residency requirements for the account holder and/or beneficiary. Investments made in mutual funds and ETFs are not federally guaranteed, but some principal-protected bank investments may be insured by the Federal Deposit Insurance Corporation (FDIC). State governments do not guarantee investments in education savings plans.
Prepaid Tuition Plan
Prepaid tuition plans allow an account holder to lock in tuition and mandatory fees at current rates for students who may not be attending a college or university (usually public and in-state) for years to come. Generally, the plan cannot be used to pay for future room and board. Additionally, it cannot be used to prepay any expenses for elementary and secondary schools.
Investment options are usually limited to money market savings vehicles, which offer modest returns on the contributions made.
Most prepaid tuition plans are sponsored by state governments and have in-state residency requirements for the account holder and/or beneficiary. Prepaid plans are not guaranteed by the federal government — some states offer a guaranteed investment while others do not.
What Are Qualified Education Expenses?
According to the IRS, qualified education expenses include amounts paid for tuition, fees and other required expenses associated with enrolling an eligible student into an eligible institution. The “other” category usually allows for the necessary tools required for an education, such as books, computers and software. Examples of expenses that do not qualify include room and board, insurance, medical expenses and transportation.
If you spend 529 plan money on acceptable items, you will not trigger any IRS penalties. However, you must ensure all spending is in accordance with the guidelines that govern your particular plan. If you are having any difficulty assessing the terms, you should consult with a tax professional.
529 Plan Fees
The 529 plan fees and expenses vary depending on the type of plan you open, how you open it and the underlying investments you select.
- Prepaid tuition plans usually charge enrollment and application fees, as well as ongoing administrative fees.
- Education savings plans usually charge enrollment and application fees, ongoing account and program maintenance fees, and ongoing asset management fees. Investors that purchase a plan through a broker are subject to additional fees, including commissions, investment sales loads and redemption charges.
Pros and Cons of 529 Plans
529 plans have more advantages than disadvantages, and the disadvantages can be largely avoided through careful planning and fiscal discipline.
One of the most prominent benefits of the 529 plan is the ability to grow and withdraw funds without paying any federal income tax and state income tax. Additionally, some 529 plans provide state income tax deductions and credits. However, to claim them, you must utilize a 529 plan offered by your home state.
Some other benefits of the 529 plans include its high annual contribution limits, which are higher than most tax-advantaged vehicles — $16,000 in 2022.
Plus, 529 plans can be implemented in a passive manner, requiring little hands-on effort, and there is flexibility around withdrawing funds without a penalty if the beneficiary decides to not attend school.
The main downside to 529 plans is its aggregate contribution limits. The limits range from $235,000 to $550,000 depending on the state.
Choosing a 529 Plan
You are not limited to your state’s 529 plan. You can open a plan sponsored by other states. Doing so may reduce your tax benefits but could be sensible if your home state’s plan has inferior investment options or excessive fees.
When comparing 529 plans, be sure to consider the state income tax benefits, the breadth of the investment options, the historical performance of those investments, as well as all upfront and ongoing administrative fees.
The most competitive plans offer a range of investment options that can satisfy your investment objectives in an economical fashion. Top-tier plans offer target-date funds that dynamically adjust over time. This allows you to shift away from volatile growth assets and into more stable, fixed-income assets as the plan’s spending date nears.
The best plans are also low cost, with some eliminating enrollment fees, transfer fees and trading commissions.
Keep in mind that it’s not uncommon for plans to have a minimum initial investment requirement — usually, a few thousand dollars.
Opening a 529 Plan
Opening a 529 plan is easy to do. Essentially, you can pursue one of the following two options.
- Direct-Sold 529 Plan – This option entails opening an account directly with your preferred state sponsor through its website.
- Advisor-Sold 529 Plan – This option entails opening an account through a licensed financial advisor.
Direct-sold plans usually charge lower fees than advisor-sold plans. However, advisor-sold plans usually offer a broader range of investment options and customized advice.
If you already work with a financial advisor, the smart thing to do is consult with him or her. You may be able to leverage your existing brokerage platform to streamline the process.
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8 Cited Research Articles
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- Federal Deposit Insurance Corporation. (n.d.). About. Retrieved from https://www.fdic.gov/about/
- Internal Revenue Service. (2021, November 3). Qualified Education Expenses. Retrieved from https://www.irs.gov/credits-deductions/individuals/qualified-ed-expenses
- Internal Revenue Service. (2022, August 3). Topic No. 313 Qualified Tuition Programs (QTPs). Retrieved from https://www.irs.gov/taxtopics/tc313
- Investor.gov. (n.d.). Exchange-Traded Fund. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/glossary/exchange-traded-fund-etf
- Investor.gov. (n.d.). Mutual Funds. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/glossary/mutual-funds
- Investor.gov. (n.d.). Risk and Return. Retrieved from https://www.investor.gov/additional-resources/information/youth/teachers-classroom-resources/risk-and-return
- U.S. Securities and Exchange Commission. (2018, May 29). An Introduction to 529 Plans. Retrieved from https://www.sec.gov/reportspubs/investor-publications/investorpubsintro529htm.html