How do 529 plans work?

What is a 529 plan?

Named after Section 529 of the Internal Revenue Code, 529 education saving plans which are legally known as qualified tuition plans, can help parents and grandparents save for a child’s future education. In short, 529 plans are investment accounts that use after-tax funds to grow tax-deferred and offer tax-free withdrawals when used for education.

Each state has at least one 529 college savings plan available, and they are designed to have tax advantages. When you purchase a state 529 plan, each account will have a beneficiary and an owner who controls how the funds are invested. When considering a 529 plan, there are two main types — Education Saving Plans and Prepaid Tuition Plans — and each is designed differently. Having a 529 plan does not guarantee acceptance to an educational institution.

Some types of 529 plans, such as Education Savings Plans, may be used for expenses beyond college such as K-12 tuition, apprenticeship programs and loan repayments while leftover funds may be be used to fund a Roth IRA.

Types of 529 plans

Education Savings Plan

Between the two types of savings plans, an Education Savings Plan is more common. Money is invested into the plan (much like a 401(k)) and the investor selects the type of investment — typically a mutual fund, exchange-traded fund (ETF) or principal-protected bank product. The investor may switch the investment twice per calendar year based on fluctuations that may occur over time. Starting a fund early allows it to grow and accumulate over many years.

Fees may be assessed for enrollment, account maintenance fees, program management and asset management.

Prepaid Tuition Plan

Prepaid Tuition Plans allow the investor to purchase future tuition at today’s price by purchasing units or credits that are meant to match the growth rate of a college’s tuition. Since these are paid out by the state, prepaid plans are typically used within the same state you purchased the plan and may not cover certain schools.

Plans vary from state to state — some states guarantee the money paid into the plan while other states don’t. With a Prepaid Tuition Plan, fees may apply for the enrollment and administration.

Private College 529 Plan

As the name might suggest, a Private College 529 Plan differs from a standard plan in that it allows funds to be utilized for a variety of private colleges. Each plan includes a set of participating private colleges and universities across the country which allow the plans to match the growth rate of their tuition. A common strategy is to couple this type of plan with a standard 529 plan to get the advantages of both and help cover other expenses such as housing or books.

529 plan qualified expenses

So how does a 529 plan work? Now that you know what types are available, let’s talk about what you can use these funds for.

Education Savings Plans are relatively flexible and may be used for a variety of costs related to education including:

• College, graduate or vocation school tuition and fees
• Books and school supplies
• Student loan payments
• Room and board
• Computers, internet and software used for schoolwork
• Special needs and accessibility equipment related to education
• Up to $10,000 annually towards tuition and fees for kindergarten through 12th grade (not available in all states)

Prepaid Tuition Plans, on the other hand, have more restrictions and typically apply to college tuition and fees exclusively – not K-12, equipment, room or board.

529 plan tax benefits

In addition to being tax-deferred and payments being tax-free, many states offer 529 tax benefits such as state income tax deductions and tax credit when funds are used for a state 529 plan. You can contribute as much as you want to the plan each year but depending on the state where you live, there are caps on both the amount that you can deduct on your state taxes and the total you’ll be able to keep in the account. If you contribute more than $18,000 in 2024, you may need to pay a gift tax unless you itemize the gift over five years on your taxes.

Another key benefit to 529 plans is that in some states they avoid negatively affecting the child’s ability to qualify for financial aid as other types of college saving plans might. Before jumping into a plan, look at what’s available in your state and compare different plans to find one that works for you.

If the college you’d like to invest in isn’t in your state of residence, you may still be able to invest but know that you may not receive the tax break or other state-specific benefits.

What if there is money left in the 529 account?

When money is left in a student’s account, there could be a few options:

• Keep the money in the account in case the child decides to further their education.
• Transfer the amount left into the 529 account of another eligible family member.
• Use up to $10,000 to pay off private or federal loans.
• Roll your money over into a Roth IRA.
  • The Roth IRA must be in the name of the beneficiary.
  • The 529 account would need to have been owned for a minimum of 15 years.
  • Contributions made to a 529 plan in the last five years are ineligible for rollover.
  • The rollover amount is subject to and is considered as a Roth IRA contribution up to the annual limit – which is $7,000 as of 2024. It may take several years to roll over your 529 balance.
  • There is a lifetime limit of $35,000 that you can roll over from the 529 account.
• Cash out the remaining balance. State and federal taxes will likely be due on the amount as well as a 10% penalty fee.

Other types of college savings accounts

Coverdell Education Savings Account (ESA)

A Coverdell ESA is a trust that lets you contribute funds earmarked for future educational costs (elementary and secondary education through college and graduate school), up to $2,000 per year, per child. Contributions can begin at birth and continue until a child turns 18 years of age. Coverdell ESA accounts are exempt from federal income tax and withdrawals are tax-free if used for qualified education expenses. Additionally, the funds can be transferred to a sibling if your child doesn’t need them.

UGMA

Uniform Gift to Minors Act (UGMA) accounts are designed to hold and protect assets for the benefit of a minor. With this type of account, you can make monetary gifts without setting up a trust. Assets can be used for any reason at any time for the benefit of the named beneficiary and the minor gains control of the funds when they reach the age of trust termination (this is typically 18-21, depending on state and account restrictions). Assets can be used for education expenses, but because assets are considered the property of the beneficiary, there may be a significant impact on financial aid.

UTMA

Uniform Transfer to Minors Act (UTMA) accounts are almost identical to UGMA accounts with the exception that they also allow individuals to hold and protect physical property such as a vehicle or real estate.

What if the child doesn’t attend college?

If the intended recipient doesn't attend college, the funds in the 529 can be used for different educational pursuits, such as trade school or vocational schools (e.g. cosmetology or culinary arts). In addition, the 529 plan could be transferred to another family member or relative — even a future grandchild. If no one plans to use the funds, they may be withdrawn with federal and state taxes being applied along with a penalty, which is typically around 10%. Notably, UGMA and UTMA accounts do not have these restrictions as their funds may be used for whatever the beneficiary would like.

As you think about saving for college, it’s helpful to know the current average cost of higher education. Also, as parents move away from childcare expenses, it could be a good opportunity to take those funds and apply them to a college savings account. After all, you may already be accustomed to living without that income. You can also use a college savings calculator to help determine how much the anticipated future cost of college might be.

If a 529 plan seems right for you, with the help of your State Farm® registered agent, you can develop a college savings plan based on your risk tolerance, timeframe and personal family and financial situation.