What’s a 529 plan?

When your kids are younger, it’s hard to imagine they’ll ever be old enough for college. But, I assure you, that day will come. In fact, it’ll come screaming into view faster than the speed of light. While time is flying by, make sure you’re saving for their education with a 529 plan.

529 plans were introduced in 1996 to help taxpayers (you) prepare to pay college expenses for a designated beneficiary. Earnings in these plans are exempt from federal taxes, and each plan is sponsored by a state, state agency, or educational institution. Note that you aren’t restricted to using your own state's 529 plan. A 529 plan is an investment plan, much like a 401(k) or an IRA.

What are the benefits of a 529 plan?

Contributions to a 529 are made with after-tax dollars, and all earnings and qualified distributions (withdrawals) are tax-free -- they’re not treated as taxable income. That means the earlier you start contributing to a plan, the better, as you’ll have more time for compound growth that won’t be taxed.

Another big appeal is that you can transfer a 529 plan to another qualifying beneficiary without tax penalties. So, for example, if your intended beneficiary graduates from high school and decides not to go to college, you can designate another child or relative or even yourself as the new beneficiary (the money must still be used for qualified education expenses). Also, unlike some other types of investment/savings accounts, 529s do not affect your child’s qualification for federal financial aid because they’re not considered to be assets of the minor.

What can I use my 529 savings for?

You can use distributions (withdrawals) from a 529 to pay qualified tuition expenses for elementary, secondary, or college education. (Before the recent tax reform in 2018, you could only use 529 funds for college education. The rules were expanded in 2018 to include elementary and secondary education tuition as well.) At the college level, distributions can also be used to pay for books, supplies, and room and board.

There are two types of 529 plans: Prepaid Tuition Plans and Education Savings Plans. Savers tend to prefer the flexibility of Education Savings Plans vs. Prepaid Tuition Plans. Read more to see what might work best for you.

529 Prepaid Tuition Plans

Prepaid plans allow you to lock in today’s current tuition price for tuition credits that your beneficiary can use in the future at participating universities. This can make financial sense when you consider that the average price of a public college education has gone up 237% over the last 20 years, according to US News and World Report.

However, if your beneficiary decides not to attend a participating university, the prepaid 529 plan will likely have strict rules around how much your prepaid tuition credits are now worth and how you may recoup your investment. Many investors don’t like the inflexibility of 529 Prepaid Tuition Plans and prefer the more flexible 529 Education Savings Plan.

529 Education Savings Plans

529 Education Savings Plans allow for more flexibility, as beneficiaries can use their withdrawals to pay for qualified tuition, room, board, and supplies at any US college or university. 529 Education Savings Plans can also be used to pay up to $10,000 per year for qualified tuition at elementary or secondary schools.

Investment options within the plan can include mutual funds and exchange-traded funds (ETFs), and many financial institutions offer age-based portfolios that are similar to the target-date portfolios used in retirement accounts. With the age-based portfolios, asset allocations start off more aggressive when the beneficiary is younger and then shift to a more conservative approach as the beneficiary reaches college age to help protect the funds in the account and prepare to pay that first tuition bill!

With most 529 Education Savings Plans, there are certain fees that apply. You should weigh both in-state tax deductions and annual plan fees when you compare costs of different plans to make sure you find the best deal for a given type of plan. Some states also provide tax benefits to investing in 529 plans, and you’ll need to check your state's rules for tax consequences.

The bottom line: 529 plans are a great way to save for education costs

529s can be a smart way to save for education expenses -- you can grow your savings tax-free, and you may even get some state tax benefits for your contributions. Whether your child is 12 months or 12 years old, now could be the right time to start putting a little away for college in a 529 and letting compound interest work its magic.