529 Plan

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As a parent, grandparent, guardian, or even an aunt or uncle, you want the best for the children you love and take care of. In addition to paying for club team fees, piano lessons and food, clothing and shelter, you’re entrusted with helping a child make his or her way in the world. You may wonder about how, in addition to these expenses, you should save for college.

Tuition, room, board, and fees cost on average $10,560 for in-state students at four-year public colleges, according to the College Board. The same expenditures at four-year private nonprofit institutions average $37,650 during the 2020-2021 academic year.

Let’s say you’re wondering about the costs of college in 10 years for your current eight-year-old. If you calculate the cost of your favorite private college based on today’s dollars — $45,000, with a hypothetical college cost inflation rate of 5%, college will cost close to $316,000 (merit-based scholarships and grants not included).

Let’s say you want to consider the cost of a state school instead of a private institution at the same cost inflation rate as the previous example (5%). Let’s say you look up the cost of attendance of your alma mater in today’s dollars and find out that it’s $22,000. You’d pay about $151,000 total over the course of four years (again, without merit-based scholarships or grants included in that figure).

Knowing those sobering statistics (and knowing the costs will go even higher for a younger child), you may want to consider using a 529 college savings plan to save for college.

Our guide to saving for a child’s education defines a 529 plan as a popular tool used to save for future college expenses. In this article, we’ll explore the types of 529 plans, the benefits of a 529 plan, what you can consider before investing in a 529 plan and how to choose one for your needs.

Types of 529 Plans

A 529 plan is named after Section 529 of the Internal Revenue Code (IRC), which authorizes tax-free status for qualified tuition programs.

You can use the money secured in a 529 plan to pay for a wide range of education expenses, including tuition, room, board and fees. Some types of 529 plans allow you to count other items, such as laptops, supplies for classes and more as “qualified” tuition expenses. You’ll need to know the specific requirements for each of these types of expenses to be considered qualified education expenses.

That said, let’s go into detail about two types of 529 plans: prepaid tuition plans and investment savings plans.

Prepaid Tuition Plans

The first type of 529 plan, a prepaid tuition plan, locks in a specific amount of future tuition at today’s prices. In other words, you can buy four years of college now for your very young child (even a baby!) and pay tuition at today’s prices instead of what college will cost 18 years from now.

State governments typically sponsor these plans and residents of that particular state can take advantage of them. In some situations (but not many), private organizations sponsor these types of plans, which do not offer investment opportunities like other types of investment options.

Here’s how it works in a nutshell: You pay for the amount of tuition you want in the form of years, credits or units. You can choose to pay in one lump sum or through installment payments. A number of options exist, whether you opt early for a two-year community college or a four-year undergraduate program. Some plans even allow you to cover graduate school tuition.

Though you get a leg up on avoiding college cost inflation, you can point to several drawbacks to prepaid tuition plans, including the following:

You can only choose from an in-state public institution. If your child later wants to go to a private college or a school out of state, you’ve limited your options by using a prepaid tuition plan.

You can’t cover all eligible expenses: As previously mentioned, you could spend money on a variety of educational expenses, but not with a prepaid tuition plan. In this case, you can only prepay tuition — not room and board or fees, for example.

Your state could shut down the state program. In some cases, the state in which you live could shut down your prepaid tuition program. For example, Illinois’ prepaid college tuition program, the College Illinois! prepaid tuition program, has on-and-off started and stopped accepting new participants over the years because it does not have the money to fulfill its projected obligations.

Investment Savings Plans

529 investment savings plans give you the opportunity to invest in stocks, bonds and mutual funds. Unlike prepaid tuition plans, your child isn’t restricted to staying in the state where he or she lives or attending a certain school (like a public university). It’s important to realize that these plans include an element of risk because it’s possible to lose money through your investments.

However, many 529 investment savings plans also adjust your risk profile from aggressive to become more conservative as your child matures. So, for example, by the time your child turns 13, the asset allocation (which refers to investing based on your goals) will become more conservative because your child has only five years before turning 18.

A 529 investment savings plan is usually also sponsored by a state. However, you don’t have to invest in your state’s 529 plan. If you see another state’s investing options and you like those better, you can choose to go that route.

However, check on the tax benefits. Will you still qualify for the full range of income tax deductions?

You can use the money you save at any of the following eligible educational institutions, including:

Postsecondary trade and vocational schools
Two- and four-year colleges
Postgraduate programs
K-12 public, private or religious institutions (for tuition only)
Certified apprenticeship programs

You can also use the funds in a 529 investment savings plan to pay for qualified student loans of your beneficiary or beneficiaries. (A beneficiary refers to the person for whom you open an account.) Anyone can contribute on behalf of a beneficiary — parents, stepparents, aunts, uncles, grandparents — anyone who wants to save money for a child’s college education.

How much can you save? Fortunately, you can save a lot of money in a 529 plan. Federal law says that contributions to a 529 plan cannot exceed the expected cost of your beneficiary’s stated college expenses. Limits vary by state and can range from $230,000 to $530,000.

Benefits of a 529 Plan

So, why a 529 plan? You have many choices at your disposal. You may have heard about a Coverdell education savings account (ESA) and that you can use a Roth IRA for college savings as well. (Check out Coverdell ESA vs. 529 Plans or Title 529 plan vs. Roth IRA for more information on both.)

You may wonder, based on all these options, why so many people choose to invest in 529 plans. Let’s take a look at the many perks 529 investment savings plans offer:

Tax advantages: Tax breaks give 529 plans an edge. As long as you use them for qualified (key word is qualified) educational expenses, many states allow full or partial tax deductions for 529 plan contributors in the form of income state tax deductions and state tax credits. Your investment grows on a tax-deferred basis and you can withdraw money tax-free when it’s time for your child to head off to college. However, you cannot deduct contributions from your federal income taxes.

More than one use: You may want to consider using a 529 investment savings plan as an estate planning vehicle. However, you’ll want to mind the federal gift tax. You can exclude the first $15,000 of gifts to each beneficiary (or $30,000 to married couples filing jointly). However, you can superfund a 529 plan, which means that you can treat a contribution of $75,000 ($150,000 for married couples) as if you applied it over a five-year period.

How you use them also makes a difference. They can be used at a state university, a trade school and even for professional school, such as medical school. You can even use them to pay up to $10,000 of student loan debt.

Won’t face income-based restrictions: Some types of college savings vehicles, such as Coverdell ESAs, require you to meet certain income qualifications in order to contribute. However, 529 plans don’t set such restrictions. You can qualify for federal tax breaks on 529 earnings no matter what you bring in every month.

Can switch your investments: You can change your asset allocation if you don’t like how your 529 investment plan is performing. However, learn more about how many times per year you’re allowed to make those changes — your state plan may only allow you to change your investments up to two times per year, for example.

Can change beneficiaries: 529 plans allow you to change beneficiaries. Let’s say you discover that your oldest daughter has no interest in attending college by the time she’s a freshman in high school. You can leave the account in her name (in case she changes her mind) or if you know for sure that she won’t attend college, you can choose to switch the account to another beneficiary.

Next, we’ll go over the things you should consider before you choose a 529 plan for your college savings vehicle.

What to Consider Before Investing in a 529 Plan

It’s always a good idea to weigh the pros and cons before you decide on the right college savings plan for you and your beneficiaries, no matter if you’re saving for your own children, grandchildren, nieces or nephews.

Tax penalties: If you don’t withdraw your money and use it to pay for a qualified educational expense, you’ll pay federal and state income taxes as well as a 10% federal income tax penalty on the earnings for nonqualified withdrawals.

Could limit your beneficiary’s financial aid access: When your family files the Free Application for Federal Student Aid (FAFSA). Your 529 savings could count against your student in terms of federal aid if the 529 plan is under your student’s name and not yours. Each school has a specific financial aid formula, but typically, a 529 plan in a student’s name may reduce his or her access to funds from the Department of Education, though he or she will always qualify for unsubsidized federal student loans.

Whether you want to use the money for K-12 expenses: If you use the money you invest for K-12 expenses, it doesn’t give it much time to grow. In addition, you might not have enough money in your account for college if you use the bulk of it for private school tuition starting in kindergarten.

Penalties for withdrawing early: If you get antsy and withdraw early because you know college is coming soon, you could pay for it. You must make a withdrawal in the same year as you pay for a qualified education expense. Ask your 529 plan you’ve invested in for the details on when you can withdraw.

Ultimately, the state 529 plan you choose should be able to answer any questions you have about your particular situation.

How to Choose a 529 Plan

Are you positive that a 529 plan makes sense for your needs and your beneficiary‘s (or beneficiaries’) needs? Or are you still tossing around various ideas? If so, that’s understandable. It’s so hard to make the leap to choosing the right plan because it’s such an important decision.

You may want to start with Personal Capital’s Education Planner, which can help you understand and compare the costs of any given college. It can help you track your progress and even model what a fifth year in college might look like. You can also see how hypothetical changes to education goals can impact your overall portfolio and how saving for college can integrate with your other savings goals, such as saving for retirement.

Take a look at these other tips as well:

Compare costs. Some plans charge more in fees than others.

Understand your investment options and investment goals. Doing so can help you choose the right plan for you.

Learn about the tax benefits. Does your state offer ample tax benefits in your state’s 529 plan? If not, you might want to look elsewhere, for other 529 plans that offer other benefits.

Know how having a 529 plan could affect financial aid. Get personalized financial advice through Personal Capital to walk you through how a 529 plan can affect the results of the FAFSA.

Doing your due diligence and doing some quick research will ultimately help you make the right decision for your needs.

529 Plan FAQs

What are the drawbacks of a 529 plan?

You may want to consider a few drawbacks before you choose a 529 plan. They can limit your beneficiary’s access to federal financial aid and financial aid awarded by the college of his or her choice. You may pay tax penalties if you don’t use your money to pay for qualified educational expenses.

In addition, you could use up a large portion of the money in your account if you use it for K-12 private school tuition. Finally, you may not have access to a huge range of investment options like you might if you invest with a regular brokerage account.

Can you lose all your money in a 529 plan?

Investments like a 529 plan always incorporate an element of risk, and it is possible to lose money in your 529 plan. You can mitigate risk by investing more conservatively as your child gets older, but you can still lose money, especially in the event of a market downturn.

What is the advantage of a 529 plan for saving for college?

529 plans offer multiple advantages, including tax incentives, which remain one of the most popular reasons for choosing a 529 plan.

What is the minimum to invest in a 529 plan?

Generally, you want to take a look at what your individual plan offers to determine the minimum investment amount. In many cases, you won’t have to make a specific minimum investment to open or contribute to a 529 account. However, with automatic investing plans, you might face a few more restrictions. For example, the minimum contribution level might go up to $15 per month or $45 per quarter and the additional contribution minimum may go to $25.

What should you do if you have an overfunded 529 plan?

Believe it or not, it happens. Here’s what you can do if you have an overfunded 529 plan (luckily, you have a few options). You can:

Keep the money in the account for graduate school.
Change the beneficiary designation to another beneficiary.
Save the money for grandchildren.
Look into penalty-free nonqualified withdrawal options.
Pay for K-12 private school expenses.

Still interested in learning more about saving for college? Take a look at three things you didn’t know about 529 college savings plans and manage your money better with Personal Capital’s free financial tools.

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Personal Capital compensates Melissa Brock (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.