Have children, or thinking about kids someday? According to the College Board, the average cost of college tuition has soared to $28,840 per year for in-state schools and $60,420 for private schools, which means you can’t start saving soon enough.
Luckily, the government incentivizes savers through a unique program, known as the 529 plan, which offers tax-free funds to use towards tuition and other qualified college expenses.
Due to changes introduced by the SECURE 2.0 Act, which took effect in 2024, 529 plans now offer their beneficiaries significant tax advantages after they receive their diplomas, too.
Related: What is the Earned Income Tax Credit in 2023 and 2024? Who is eligible?
529 plans have been around since 1996, but they were mainly a savings vehicle for high-income families, according to a study by the Government Accountability Office (GAO). In 2015, it was reported that only 3% of Americans were saving through these accounts, and that they had a median income of $142,000.
But as the price of tuition skyrocketed, 529s have grown in popularity, according to Sallie Mae, the country’s largest student loan provider. 33% of students used a 529 plan to fund their college expenses in 2022, which breaks down to 16 million families with an average account balance of $25,630.
Not only are 529 plans very flexible; they also have significant tax advantages that don’t have anything to do with your federal tax returns, although some states offer tax credits for certain plans.
As part of the SECURE 2.0 Act of 2022, 529 plan account holders are now allowed to roll over up to $35,000 in unused funds into a Roth IRA, and that could help their recent grads save for retirement, buy their first home, or get their careers off the ground.
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What is a 529 education savings plan?
Formally known as “qualified tuition plans” and federally authorized by section 529 of the Internal Revenue Code, 529 plans are sponsored by all 50 states and the District of Columbia. They are used to fund a child’s education expenses, and they offer a lot of flexibility.
Since there are multiple people involved, it’s important to understand the lingo behind 529 plans. The individual who opens the 529 plan is known as the account holder or the saver, while the child or prospective student is known as the beneficiary.
In addition, since 529 plans accept contributions from third parties, the child’s grandparents, other relatives, or friends can also contribute to this account. And if your child opts to skip college altogether, you can even make another child or grandchild the account's beneficiary.
The 2 types of 529 plans:
- Education savings plans: Education savings plans allow the saver to put aside money for tuition, fees, room and board, and other education-related expenses, like textbooks and laptops. Some plans have residency requirements for the account holder and beneficiary, so it’s important to check out the fine details of the plans offered in your state (or another state of your choice) before you enroll.
- Prepaid tuition plans: Prepaid tuition plans offer account holders the choice of purchasing credits that the beneficiary can use to “lock in” current tuition rates at a participating college and university, but it's important to note that not every state offers this type of plan.
Remember, these plans are very flexible; in fact, they’re not just for college tuition — 529 plan contributions worth up to $10,000 per year can go towards any public, private, or religious school, even elementary and high schools, although unlike college, these funds are solely authorized to cover tuition expenses.
529 plan funding can even help your child after graduation since it can also be used to pay off student loans: A maximum of $10,000 (lifetime, not per year) can be allocated to student loan repayment, as authorized by the SECURE Act of 2019.
Related: How to match your student loan payments as 401(k) contributions
How does a 529 work? Where can I open one?
There are no income qualifications for 529 plans, but account holders must be U.S. residents with a U.S. mailing address, a Social Security number, or a Tax ID.
529 plan beneficiaries must also have a Social Security number or tax ID.
Account holders invest contributions into their choice of designated mutual funds, exchange-traded funds (ETFs), target-date portfolios, or high-yield savings products. Some funds automatically redistribute allocations; others give investors the option to select their investments according to their risk profile; for example, aggressive investors might choose funds that have higher potential for gains but also greater volatility in order to achieve a shorter-term payoff.
As always, when investing in the stock market, remember that your funds are not federally guaranteed, but in some instances, certain products, like fixed-rate certificates of deposit (CDs), may be FDIC-insured.
To open a 529 plan, visit collegesavings.org, a nonpartisan organization that serves as a clearing house between state-administered college savings plans. It has created a 529 Search & Compare tool which helps you understand the differences between plans by state, including their fees, who’s managing the funds, and what their minimum and maximum contribution limits are.
Once you find a plan you like, you can sign up through the state’s website or an authorized broker. Some employers even let your 529 plan contributions be deducted directly from your paycheck.
What are the 529 plan rules? When are they taxed?
529 plans differ from other college custodial accounts. Unlike the Uniform Transfer to Minors Act (UTMA) and the Uniform Gift to Minors Act (UGMA) accounts, 529 plan account holders maintain control over the account until their funds are withdrawn.
529 plan contributions grow tax-free at the federal level, although there is no federal income tax incentive. That means you cannot deduct your 529 plan contributions from your federal taxes. However, certain state plans allow you to deduct or receive a 529 tax credit on your state tax returns.
It’s important to note that if you live in a state that doesn’t have an income tax, you won’t receive a 529 deduction. There are currently nine states in the U.S. without income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
In addition, four states have income tax but do not offer a 529 deduction: California, Hawaii, Kentucky, and New Hampshire.
You’ll also receive a penalty at tax time if you don’t use your 529 plan funds towards a qualified education expense, so be sure you understand exactly what they are. The federal government incurs a 10% penalty as well as income tax on these earnings, although no taxes are levied on the principal. If the beneficiary receives a scholarship, funds worth up to that amount can be withdrawn penalty-free.
529 plans and Roth IRAs
One drawback of 529 plans used to be that contributions could only be used toward educational expenses. But Section 126 of the SECURE 2.0 Act of 2022, which was signed into law by President Joe Biden in an effort to expand coverage and simplify retirement planning for all Americans, authorized tax- and penalty-free 529 plan rollovers into Roth IRA accounts. This Act took effect on January 1, 2024.
In order to be eligible for the Roth IRA conversion, the 529 plan must be in the beneficiary’s name for at least 15 years, and annual conversions cannot exceed the annual Roth IRA contribution limit. The lifetime rollover limit is $35,000.
The beauty of owning a Roth IRA is that anyone can withdraw contributions without incurring penalties if the account is at least 5 years old. This money can be used to purchase a home if the money goes directly towards its cost, or towards a myriad of other life expenses a new graduate may face.
