529 plan beneficiaries enjoying college

Your Complete Guide to 529 Plans

The rules around 529 plans have changed in recent years, offering more incentives and options than ever for those investing for their kids or grandkids’ education. But there are still a few factors you’ll want to consider before starting one. Here, we break down the pros and cons of today’s 529s.

Published by Motley Fool Wealth Management Originally posted on Tue, Apr 16, 2024 Last updated on April 16, 2024

read time 7 min read

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If you have young kids or grandkids at home, you’ve probably wondered what their future will look like. Are they destined to be a doctor? A writer? Or perhaps a mechanic? Whatever your child wants to be when they grow up, there are steps you can take now to help them cover the cost of pursuing their dreams.

529 plans, for example, are designed to help parents invest in their children’s future, but have you ever looked into the benefits and drawbacks of opening one? Let’s explore the basics of 529 plans, as well as how they’ve evolved in recent years to offer families more incentives than ever before.

The Basics of 529 Plans

529s, or qualified tuition programs as they’re formally called, are savings plans specifically geared toward helping individuals and families cover educational costs, such as college tuition.

The majority of 529 plans are sponsored by state governments or agencies, though some educational institutions may provide them as well. While you can certainly select a 529 plan offered through your home state, you aren’t required to (but doing so may provide further tax advantages, which we’ll touch on in a bit). It’s worth noting that a few 529 plans do include residency requirements, meaning you must live in that state to use its plans.

A 529 plan involves two people:

  • The account holder: The person who initially opens the account and funds it. Usually, this is a parent or grandparent, but it could be any adult. 
  • The beneficiary: This is the person (typically a student or future student) the account is intended for. Usually, it’s a child or grandchild of the account holder.

With that being said, someone can be both an account holder and its beneficiary— you could open and fund a 529 plan for yourself if you’d like to pursue a Master’s degree in the future, for example.

There are two types of 529 plans: education savings plans and prepaid tuition plans.

Education Savings Plans (ESPs)

With an education savings plan, the account holder essentially creates an investment account that can be used to cover qualifying education-related expenses, including:1  

  • Tuition and related fees at any college or university in the U.S. (and some international schools)
  • Room and board at a college or university
  • Tuition for grade schools (up to $10,000 per year, per beneficiary)
  • Expenses related to an apprenticeship program
  • Student loan repayments (up to $10,000 per beneficiary)

Like an FSA or HSA, you can pay up front and then reimburse yourself from the 529 plan.

Prepaid Tuition Plans

Rather than put money into an investment account, this option lets the account holder purchase credits (sometimes they’re called “units”) that the beneficiary will be able to put toward tuition at a participating institution in the future — typically public or state schools. 

Prepaid tuition plans essentially allow the account holder to “pre-pay” tuition at its current price (hence the name!). Considering the rising cost of college, this option can be attractive to a lot of parents as it enables them to send their kids off to college at a discounted price. 

Are There Any Tax Benefits to Having a 529 Plan?

Yes, and no…. And that might change in the future.

Let’s break it down.

Yes… When withdrawals from 529 plans are used on what’s considered to be qualified higher education expenses, any capital gains earned within the account are exempt from federal income tax (and most states exempt taxes here as well).2 

No… Unfortunately, you cannot deduct contributions to a 529 plan from your federal income taxes.2 However, some state plans allow you to deduct the contributions from your state income taxes. Keep in mind that this exemption may depend on whether you reside in the state that sponsors your plan. 

Possibly in the future… Keep in mind that tax laws can change. Many parents opt to start saving for college while their kids are very young, meaning they could be contributing to the account for the next 18 years or longer. It’s possible that during that time, new tax laws could pass that create more incentives for using college savings plans (like SECURE 2.0).

Do 529 Plans Impact Financial Aid?

Generally speaking, the assets held in a 529 plan may impact your student’s financial aid eligibility. 

If a 529 plan is owned by a parent or student, the funds in it will count as “parent assets” on the Free Application for Federal Student Aid (FAFSA). However, a certain amount of parental assets will fall under the “asset protection allowance,” meaning they won’t count against your student’s financial aid package. For reference, colleges anticipate that parents will use 5.64% of their “parental assets” toward their child’s tuition. 

All of this isn’t to say you should avoid using a 529 plan to save for your child’s future education costs. Many financial aid packages include student loans — which your 529 account can help your child avoid or reduce.

What Makes 529 Plans More Attractive Now?

While 529 plans were initially introduced in the 1990s, they’ve gained traction in recent years.

Rising College Costs

The cost of college continues to rise at an alarming rate which, in turn, has saddled more graduates with student loan debt. For parents and grandparents who want to help their child avoid (or at least minimize) student loans, education-focused savings accounts like 529s can be an attractive option. 

For reference, the average cost to attend a private college for the 2023-2024 academic year is $60,420 a year—or $240,960 for four years. Public colleges are typically less expensive, but still average $115,360 for four years.3 

Roth IRA Rollovers

Following the passing of the SECURE 2.0 Act in 2022, account holders can now roll over funds from a 529 account into a Roth IRA for the same beneficiary (whether that’s your child, grandchild, niece, nephew, etc.).

With this recent change, there are a few restrictions to keep in mind. First, the rollover is still subject to annual Roth IRA limits, which for 2024 are $7,000 for individuals under 50, or $8,000 for those 50 and older.4 In addition to annual limits, the total lifetime amount you may rollover from a 529 plan into a Roth IRA is $35,000. 

The ruling stipulates a few account requirements as well: 

  • The 529 plan must be open for at least 15 years,
  • Any funds you plan to roll into a Roth IRA must have been in the 529 plan for at least five years.

If you’re concerned about overfunding your 529 plan (meaning you save more than your child will need to pay for college), this change enables you to give them a head start on their retirement savings as well.

It’s also possible to change the beneficiary on the 529 to direct Roth rollovers to another person, typically the parent. In this scenario, however, some custodians will change the account number of the 529 plan, which may result in the 15 year aging requirement not being met.

Grandparent 529 FAFSA Exemptions

Starting in 2024, distributions from a 529 plan owned by someone who isn’t the parent or student (i.e. grandparents) won’t count as untaxed income on the student’s FAFSA application — meaning they aren’t required to report it.

Potential Drawbacks of 529 Plans

Before running to open an account, keep in mind that there are a few potential drawbacks to establishing a 529 plan for your children. 

Limited Investment Options

Most 529 plans include a pre-determined set of investment options, and account holders generally won’t be able to switch between the options once the account is established. As it stands now, account holders can only change their investment option twice a year, or when the beneficiary changes.1  

If you’re especially adept at investments and would like to maintain control over how your contributions are invested, you may find a 529 plan too restrictive.

Strict Withdrawal Requirements

To avoid additional taxes and penalties, the funds distributed from a 529 account must go toward qualified educational expenses (the exception being a Roth rollover). 

Even with the option to eventually roll the funds into a Roth IRA, there is a limit to how much may be rolled over ($35,000 total). With limited uses for the funds in 529 plans, account holders may want to be strategic in how much they contribute.

The good news is, you can change beneficiaries of the account as often as you like — so even if one child doesn’t use as much of the funds as anticipated, you can save them for the next one (or a grandchild). As we mentioned earlier, you could even name yourself as a beneficiary if you decide to head back to school later in life.

Prepaid Tuition Plan Limitations

The credits purchased in a prepaid tuition plan are meant to cover tuition at participating schools (again, this is typically state universities or public colleges). If your child wants to attend school out of state or at a private school, you’ll likely only be able to use the original balance of the account (what you contributed) and may be forced to forfeit investment gains.1 

Investing in Your Child’s Future

When used strategically, 529 plans can be an effective way to cover your child’s future college costs. If helping your young student graduate debt-free is one of your financial goals, be sure to research your options and talk to an advisor about the benefits or drawbacks of opening a 529 plan account. 

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[1]  “Updated Investor Bulletin: An Introduction to 529 Plans” U.S. Securities and Exchange Commission. August 31, 2023. Accessed March 26, 2024.

[2]  ”Topic no. 313, Qualified tuition programs (QTPs)” Internal Revenue Service. January 29, 2024. Accessed March 26, 2024.

[3]  “Trends in College Pricing and Student Aid 2023” CollegeBoard. November 2023. Accessed March 26, 2024.

[4]  “401(k) limit increases to $23,000 for 2024, IRA limit rises to $7,000” Internal Revenue Service. November 1, 2023. Accessed March 26, 2024.

[5]  ”How Will My 529 Plan Affect My Financial Aid?” Washington College Savings Plans. February 9, 2024. Accessed March 26, 2024.

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