What’s A 529 Plan And How Does It Work?

Whether you’re thinking about your own future or a loved one’s – like a kid or grandkid – saving for the pursuit of knowledge is never a bad idea.

The amount you should save depends on many factors, like the type of education, the institution you’re targeting and the amount of time in school you’re planning for. As a reference, $57,981 is the average amount Americans save to cover the cost of college for their kids, according to the Education Data Initiative.

But what is the best way to save and make sure your educational dollar will be stretched as far as it can go? A 529 plan might be just the ticket. In fact, the Education Data Initiative tells us that 30% of savings accounts used for education are 529 plans. That’s a higher percentage than any other education savings plan.

529 Plans: Qualified Tuition Programs

A 529 plan, or qualified tuition program, is a tax-advantaged savings plan into which you or a family member can contribute or invest money for higher education. These plans are set up and monitored at the state level, and money taken out of these accounts is tax-free as long as it’s used for educational purposes.

529 accounts can be set up for you or a family member and are transferable. So, if you set one up for yourself and then want to transfer it to someone else, you can.

Types Of 529 Plans

529 plans come in a few different shapes and sizes, so it’s important to know the differences before you select the plan that’s right for you and/or your loved ones.

Once you choose the right plan, you can begin saving by applying for a 529 plan and contributing right away. After that, the sky's the limit, as there are no restrictions on the amount you can contribute and who you can name as the beneficiary. Keep in mind that you’ll have to decide what types of stocks to invest your 529 plan in. Not sure where to put that money? Don’t worry, the plan will offer some suggestions based on your age, intentions for the funds and other factors. This is similar to what 401(k) plans offer to employees, so you might already be familiar with this type of financial advising support. 

College Savings Plans

College savings plans allow you to open an investment account for qualified education expenses. It’s important to note, this doesn’t just apply to college tuition, as you can also use it for housing as well. Room and board isn't cheap, to put it bluntly. According to the Education Data Initiative, the average cost of room and board at a 4-year institution is around $12,000 – if the student lives on campus. Off-campus living costs around $11,500. Given that, the ability to apply funds in a college savings plan to room and board is a big benefit of this type of 529 plan.

College savings plans allow you to choose from a wide range of investment options, so that provides you with some say in how your money will grow. Keep in mind that any investing comes with risk, so consulting a financial advisor is always a good idea before making any decisions.

Prepaid Tuition Plans

Participating universities and colleges allow you to purchase credits or units toward any future tuition and mandatory fees through prepaid tuition plans. This allows you to buy credits at the current rate, even if the price goes up (it usually does) before you use them. For example, if you use a prepaid tuition plan to buy a credit for $700, that’s all you will pay, even if it goes up to $800 by the time you or your beneficiary is ready to start school. In case you were wondering, prepaid tuition plans cannot be used for elementary and secondary schools, only post-secondary education, like college.

Prepaid tuition plans have less wiggle room than college savings plans. Often, these types of plans can have residency requirements for the person named on the educational savings account and the beneficiary. Prepaid tuition plans are sponsored by the states, not the federal government, so they require that either the account holder or the beneficiary lives in the state that sponsors the plan. It’s important to note that the funds can be used for an out of state college or university if the beneficiary decides not to stay in the state sponsoring the plan.

An Example Of A 529 Plan

Let’s put some real numbers behind investing in a 529 plan to help bring this concept to life. As an example, say that you’ve decided to put $10,000 away each year for your 8-year-old child to go to college. Assuming they will go off to college when they turn 18, that gives you 10 years of saving.

The table below outlines the amount of funds you would have when they’re packing their bags and heading off to the university of their choice … or the one that chose them. You’ll see it compares the funds you would have from a regular savings account with no interest, a taxable investment account and a 529 college savings plan. Your tax bracket and the annual average rate of return on your investments will factor into the amount you have at the end, so let’s plug in some sample numbers for that.

The example below assumes a 7% average annual return on your investments and a 22% tax bracket. As you can see, you would save $38,160 more using a 529 compared to a regular savings account. Due to the tax benefits of a 529 plan, you would save $9,650 more than a standard investment account. 

Pros And Cons Of 529 Plans

Now that you understand the basics of 529 college savings plans, consider the benefits and drawbacks to decide if this type of investment in your (or someone else’s) future education is a good idea. Each person’s financial and educational situation is different, so it’s important to weigh the benefits and costs carefully.

Pros

• Funds grow faster than a savings account and don't get taxed like traditional investment accounts.
• You can use the funds for a variety of educational institutions and associated costs like books and housing.
• There are no time constraints on when you can start saving or when you need to use the funds.
• The funds can be used in any state, not just the one you live in currently.
• If you start a 529 college savings plan in your name and then decide not to pursue further educational opportunities, you can transfer it to someone else.
• Student loans are expensive when it comes to interest and a 529 plan can help avoid them.

Cons

• Funds can only be used for educational purposes.
• Putting funds into a 529 plan means less money for your current monthly budget.

529 Plan FAQs

We‘ve covered a lot, but some questions may remain. Let’s take a look at some frequently asked questions about 529 college savings plans.

What happens to a 529 if the recipient doesn’t go to college?

529 plans don't necessarily need to be used for college. They can be used for any accredited postsecondary institutions that provide credit towards a bachelor’s degree, associate's, graduate/professional degree or other postsecondary credential, including trade and technical schools. Also, they can be transferred to another person.

Can I convert my 529 to a Roth IRA?

Yes, new 2024 regulations allow for a lifetime limit of up to $35,000 to be rolled into a Roth IRA.

How much can you put in a 529 per year?

There is no limit to how much you can put into a 529 plan each year.

The Bottom Line

529 college savings plans are a great way to help secure your educational future, or the educational future of your loved ones. By starting early and saving as much as your monthly budget will allow, you can utilize the tax benefits and investment income that a 529 plan affords to make your money grow and last when it’s time to use it. Ready to take charge of your financial future? You can start by signing up for the Rocket Money^SM app for help budgeting and saving for your future plans.