Saving for college can feel like a major burden. Tuition costs continue to rise; in fact, from 2008 to 2018 the average cost of college increased 25% for private institutions and nearly 30% for public ones. Many students are also graduating with an overwhelming amount of student loan debt, which currently totals a whopping $1.57 trillion, according to the credit bureau Experian.

Using a 529 college savings plan is one way parents can save money for their children’s future college expenses while taking advantage of tax savings on the fund’s investment growth. 

Find out how these plans work and how to find the best 529 college savings plan for your family.

What is a 529 plan?

A 529 college savings plan is a tax-advantaged investment account. It offers tax savings on withdrawals when the money is used for eligible education expenses. All 50 states (plus the District of Columbia) offer one or more college savings plans.

You can start saving for a child’s tuition as soon as they’re born. Compared to a standard savings account that offers an interest rate under 1%, a 529 investment account has more growth potential. Plus, you don’t have to pay any capital gains tax on those earnings, as long as you use the money for qualified education expenses for the child on the account.

529 college savings plan rules are outlined under Section 529 of the Internal Revenue Code, which authorizes the tax-free status of these plans.

The types of 529 college savings plans

There are two types of 529 savings accounts for college students to choose from: education savings plans and prepaid tuition plans.

Education savings plan

An education savings plan offers the most flexibility because your child can use the funds at any college or university for tuition, fees, and room and board. While they are sponsored by individual states, you usually don’t need to be a resident of that state in order to use the plan. You can also use up to $10,000 per year for private school tuition for both elementary and secondary schools.

Your contributions are placed in an investment account and you can choose how to invest those funds. Many states’ 529 plans provide a target-date portfolio. A fund manager controls your asset allocation based on the number of years until you plan to use the funds. As the time draws nearer, the target-date portfolio starts to shift out of riskier investments. You may also be able to craft your own portfolio using the ETFs and mutual funds available in the state-sponsored plan. The drawback with an education savings plan is that your savings are dependent on the performance of your investments.

Prepaid tuition plans

Prepaid tuition plans are typically used to save for specific in-state public schools. Instead of investing your contributions, you pre-purchase credits for a specific school or group of schools. The funds can usually only be used for tuition and fees, not room and board.

There are two risks with a prepaid tuition plan. The first is that the plan may not be guaranteed by the state, so if the sponsor goes under, you could lose all your savings. Additionally, it limits your child to the group of colleges she may attend. The reimbursement rate is low if your child ends up attending a school outside of the participating colleges in the prepaid plan.

What expenses do 529 plans cover?

One of the major benefits of a 529 plan is the variety of qualified expenses that are eligible for tax-free withdrawals. College and trade school students may use tax-free funds for qualifying expenses such as:

• Tuition
• Room and board
• School fees
• Books, computers, and other required materials
  

Additionally, parents can use up to $10,000 each year for K-12 tuition expenses. The SECURE Act of 2019 also allows students to use up to $10,000 of 529 savings to pay off their student loans.

What’s not covered by 529 plans

There are some school-related expenses that are not covered by the tax-advantaged funds in a 529 plan. Transportation to and from college along with healthcare costs are not covered, unless they’re charged by the college.

You may still use the funds for non-eligible expenses, but you’ll incur two types of tax penalties. The first is that you’ll have to pay income tax on any earnings (though not your original contribution amount) you use on non-qualified expenses. On top of that, you’ll be charged a 10% penalty fee on those distributions.

Who can open a 529 plan account?

Anyone may open a 529 college savings plan on behalf of a beneficiary. This includes parents, grandparents, friends and relatives. In fact, you can even open an account before your child is born, then transfer the beneficiary status to your child once she has a name and social security number. You can also open a 529 account for older children.

There is, however, some different treatment of the plan funds depending on who owns the account. The most common scenario is a parent (or parents) who open and own the account. When it comes time for your student to fill out the Free Application for Federal Student Aid (FAFSA), the 529 plan funds can lower the amount of need-based aid the child receives.

On the other hand, if a grandparent owns the account with the child as the beneficiary, you run into a different issue. The 529 funds don’t count on the FAFSA, but any distributions do count as income for the student. This has tax implications and must be reported on the FAFSA the following year, which can reduce federal aid.

Which states offer 529 plans?

All states plus the District of Columbia offer 529 college savings plans. But most don’t actually have residency requirements, so you can pick whichever you want. The benefit of choosing your state’s 529 plan is that many states allow you to deduct your contributions from your state income tax or qualify for a tax credit. 

The following states offer either a tax deduction or tax credit based on your 529 contributions each year (usually there’s a limit to how much you can claim as a deduction, so check your state for specifics):

Frequently asked questions about 529 college savings plans

Are there annual contribution limits for 529 plans?

The IRS does not set an annual contribution limit for 529 plans, but each state does have its own limits. Additionally, there is a federal law that prohibits 529 plan balances from exceeding the expected cost of all qualified expenses for college. You can use a 529 savings plan calculator to help you set a target savings rate to meet your child’s tuition needs. You can enter details on their age and what percentage of their tuition you’d like to cover. Most calculators account for rising tuition and room and board costs, and help you figure out how much to save compared to the potential investment growth.

Are contributions to 529 plans tax deductible?

529 plan contributions are not deductible on federal taxes. But you may be able to claim a tax deduction on your state taxes depending on where you live. Some states, like Florida and Nevada, have no state income tax, so there’s no deduction to make at all. Other states don’t offer any tax deduction. Many states offer a tax deduction up to a certain annual limit for each 529 account. If you have several children with 529 plans, the maximum contribution limit used for a tax deduction usually applies to each account, not each owner.

What if my child decides not to attend college?

You don’t lose your 529 plan money if your child doesn’t go to college, but there are some consequences. First of all, the funds don’t need to go towards a four-year degree. 529 plan money can go toward trade and vocational schools, as well as tuition for K-12.

If those options don’t apply to your child, there are a few other ways to use the funds, although the financial implications vary.

• Change beneficiaries:

  You can name another beneficiary, usually anyone related to the current beneficiary. You could also name yourself as a beneficiary if you’ve considered going back to school.
  

• Leave the funds:

  Another option is to leave the 529 alone in case your child changes his mind or someone else in the family could use the money for school later on.
  

• Take a penalty:

  You can still withdraw unused money from a 529 college saving plan, you just have to pay for it. Expect to pay federal and state income taxes on your withdrawals, plus a 10% penalty on earnings.

Can I use a 529 savings plan outside my state?

As long as you use a 529 savings plan and not a prepaid plan, the funds can go toward expenses at any eligible college or university in the country. In fact, there are even some institutions abroad that qualify for 529 plans.

The bottom line

Choosing the best savings account for college students is a major decision for many parents. A 529 college savings plan is one resource to know due to its tax treatment and flexibility for both eligible institutions and qualified expenses.