How 529 College Savings Plans Work

Saving for college may feel overwhelming, but using a 529 plan can make the process more doable. That’s because 529 plans aren’t simply a savings account. Officially called qualified tuition plans, 529 college savings plans offer tax breaks, flexibility, and more for those investing in the future.

There are two types of 529 plans: education savings plans and prepaid tuition plans. With education savings plans, an account holder opens an investment account to save for a beneficiary’s future qualified higher education expenses. These expenses include everything from tuition to fees to room and board at most colleges and universities throughout the U.S., and even some non-U.S. institutions. Funds can usually be used for apprenticeship fees, too. What’s more, in some states, you can use 529 plans to pay up to $10,000 a year for tuition at K-12 public, private, and religious schools.

Each state has its own 529 education savings plan, but most plans allow anyone to open and contribute to a plan. Don't assume your state's plan is the best one for you to contribute to. But be aware that the state tax benefits might not apply if you don't live there.

Prepaid tuition plans are a type of 529 plan that essentially pre-pays for tuition and mandatory fees at specific schools, locking in today’s prices for the future. This is a great way to beat inflation—tuition is almost guaranteed to rise over time—but these plans offer less flexibility in how you use them and where.

Most prepaid tuition plans are tied to specific public colleges and universities within a state. Because of this, you usually need to be a resident to contribute to a state-specific plan. Some groups of private colleges and universities run prepaid tuition plans.

If your beneficiary decides to attend a school not included in your prepaid tuition plan, your plan details determine your options for using the funds. For instance, you may receive a refund or the option to rollover to a traditional 529 savings plan. If you get a refund, your return on your contributions could be diminished—it all depends on the specifics of your plan. It’s smart to thoroughly research the ins and outs of a prepaid tuition plan before contributing.

Another thing to keep in mind: some state governments guarantee the money paid into the prepaid plans, but not all. If you contribute to a prepaid plan that is not guaranteed, you could lose all or some of your contributions if the plan has financial issues.

With traditional education savings plans, an account holder chooses from a range of investment options, like mutual funds, exchange-traded funds (ETFs), and bank products that protect the principal investment. These could be hand-picked by the account holder, or part of a preset or age-based mix that gets more conservative the closer the beneficiary gets to college age.

Like any investment, you’ll want to consider the risk-reward tradeoff. If you need the money sooner—say, for school tuition for a younger child—you’ll probably want to opt for lower-risk investments that will likely make less money but are considered “safer.” If you’ve got college in mind for a newborn, you’ve got more time on your hands and can consider higher-risk investments.

Although most 529 plans have a good performance history, no one can predict market performance. If part of your 529 plan is invested in principal-protected bank products, those are likely insured by the FDIC. But any investments in mutual funds and ETFs are not federally guaranteed. This means you can lose money in an education savings plan, just like any other investment.

Although there is some risk with a 529 education savings plan—as with any investment—there are rewards, too. Namely, tax breaks on contributions. The exact tax benefit an individual receives depends on factors like their state of residence and the specific 529 plan they’re investing in. That said, most states offer tax breaks for contributions to a 529 plan, either by deducting contributions from your state income tax or offering matching grants.

When it comes time to withdraw funds for qualified higher education expenses or other allowable uses, earnings in the 529 account are not subject to federal income tax—and in most cases, you won’t pay state income tax, either. Withdrawals used incorrectly are subject to state and federal income taxes, plus an additional 10% federal penalty on any earnings.

There is a notable exception to withdrawal penalties: you can roll 529 funds into a Roth IRA account for the same named beneficiary with no tax penalty. For instance, if there is money left in your 529 account after the beneficiary finishes college, you can roll the money into a Roth IRA for them instead of paying penalties for withdrawing the funds. There are a few restrictions. Total rollover is limited to $35,000 and the 529 account must be open for at least 15 years prior to rollover, with any rolled over funds in the account for at least 5 years. This rollover is also subject to annual Roth IRA contribution limits.

The amount to contribute to a 529 plan depends on what fits your budget and goals. You’ll also want to consider the cost of public vs. private education and how long you have to save. The maximum contribution for most plans is $350,000 per beneficiary. But contributions to 529 plans are subject to the annual gift tax exclusion limit. In 2024, this means you can contribute up to $17,00 per year, per beneficiary without filing and potentially paying a gift tax. There are exceptions to this, though, so consult a tax advisor for more details.

Note that money in a 529 account will likely impact a student’s eligibility for need-based financial aid. But with a majority of financial aid for many families including student loans, it’s never a bad idea to save now to avoid future debt. A 529 plan is a strategic savings tool that can make a major difference when saving for a post-secondary education.