Many people begin looking into tax-advantaged 529 plans soon after the arrival of their first baby. But it can be daunting for a first-time saver (and sleep-deprived parent) to sort through the many different options, rules, and tax angles that these accounts involve. In this article, we explore the basics of 529 plans and highlight some of the risks that you should aim to avoid.
Key Takeaways
- There are two basic types of 529 plans: education savings plans and prepaid tuition plans. The savings plans are more widely used.
- While originally limited to college costs, 529 savings plans can now cover certain K–12 expenses as well.
- It’s best to start funding your plan as early as possible. The longer your 529 account can compound tax free, the more it will grow.
- Every state offers one or more 529 plans, and most provide tax breaks if you invest in them. However, you don’t have to invest in your own state’s plan.
- 529 plans have some risks, but they’re still one of the best and easiest ways to invest for your child’s education.
What Is a 529 Plan?
A 529 plan, more formally known as a qualified tuition plan, is a way to save money to pay a child’s (or other family member’s) education expenses. The “529” comes from Section 529 of the Internal Revenue Code, which allows for contributions to grow tax deferred and be withdrawn tax free if you use them for qualified education expenses, such as tuition, room and board, and required fees.
All 50 states and the District of Columbia offer at least one 529 plan, and most provide a tax deduction or credit for 529 contributions to their plans (and some even allow a deduction if you contribute to another state’s plans). The federal government offers no up-front tax deduction but won’t tax your withdrawals if, as mentioned, you use them for expenses that qualify.
The Two Types of 529 Plans
529 Education Savings Plans
These are what most people think of when you mention a 529 plan. They were originally designed to pay only for postsecondary education costs, such as college tuition. But in 2017, the Tax Cuts and Jobs Act (TCJA) expanded them to cover certain costs associated with K–12 education. Then the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 expanded them further, allowing participants to use the money to cover expenses associated with qualified apprenticeship programs as well as repay up to $10,000 in student loan debt.
While the states sponsor 529 plans, they may delegate the actual management of the money to large mutual fund companies and other professional investment firms. Most states offer a menu of different plans that invest in different types of securities and vary in risk accordingly. For example, a 529 plan that invests in stocks may have greater growth potential but be more volatile than one that invests in bonds or a mix of stocks and bonds. When you open your account, you can decide which particular plans to invest in and divide your money among several if you wish. You can also move money among accounts later if you want to.
529 Prepaid Tuition Plans
The other type of 529 plan is the prepaid tuition plan, which allows you to pay for future tuition at today’s prices at participating colleges and universities. These plans are also generally sponsored by state governments. But unlike 529 education savings plans, the prepaid plans don’t cover room and board and can’t be used for elementary or secondary school.
There are risks to consider with either type of 529 plan.
Risk No. 1: Procrastinating
If you’re just getting started in saving for a child’s education, it can be tempting to toss some 529 plan brochures into your bottom desk drawer and bookmark a few websites to worry about later. Putting it off is the first and probably biggest risk that you face.
College costs tend to rise much faster than most other things. By one estimate, college tuition rises about 8% a year, twice the rate of inflation overall. That means that the price of tuition can double every nine years.
So, the sooner you can get started, the better. Any money that you invest in your child’s first year of life will have 17 or 18 years to compound, on a tax-free basis, by the time they’re ready for college.
Fortunately, you can often open a 529 account with as little as $10 or $15 and arrange for regular monthly deposits of a similar amount through your bank account. Your employer may offer a similar plan through payroll deductions. The more automatic you can make your 529 savings, the less you will have to think about it—and the more money that you’re likely to accumulate over time.
Risk No. 2: Picking a Poor Fund
While this isn’t as much of a problem as it was in the early days of 529 plans, some states’ funds don’t perform as well as others. Some also have higher expenses. Either (or both) of those can be a drag on the growth of your 529 balance.
If your state offers you a tax deduction or credit for your 529 contributions, one of its funds may still be your best bet, even if its performance lags a bit or its expenses are a little higher. But bear in mind that you don’t have to invest with your own state and are free to shop around. Investopedia publishes a periodically updated list of the best 529 plans, which also includes a table listing the expense ratios for every state’s direct-sold 529 plans. (Those are the plans that you buy directly from the state, as opposed to going through a broker and paying an additional commission.)
Risk No. 3: A Market Crash at the Worst Possible Time
Like other types of investments, particularly those involving the stock market, your 529 account balance will have its ups and downs. You face a risk that it will be way down right when you need to make withdrawals. One hedge against that is diversification: If you have several accounts with different types of investments, they may not all be down at the same time. You can withdraw from one that’s doing well and allow any that are ailing some time to recover.
To help address this problem, many 529 plans now offer target-date or age-based funds. These funds adjust their investment strategy over time, starting out aggressive (think stocks) and becoming more conservative (think bonds) over time. The idea is that you can afford to take more risk with your money (in hopes of a greater return) in the early years because you’ll have more time to recover from any losses. If your child is starting college in the fall, however, you want to know that the money will be there, period, when you need it.
Risk No. 4: Prepaying Tuition for the Wrong School
Prepaid plans aren’t subject to the same market risks as savings plans, and you don’t have to make any decisions on how your money will be invested. That’s up to the plan’s managers. However, these plans have some risks of their own.
First, while states sponsor the prepaid plans, not all states guarantee them, so it’s possible that your money won’t go as far as you expected it to—or, worst-case scenario, you might even lose it.
Besides that, prepaid plans are considerably more restrictive in terms of where the child can attend college. In general, a student can use the money to pay for tuition at a different school if they decide that they would rather go elsewhere. But in that event, the plan may pay less than if they had gone to the participating college or university for which you originally signed up.
Important
If your child doesn’t go to college or doesn’t use up all the money in your 529 savings account, you can change the account beneficiary to another family member, such as a sibling, a niece or nephew, a first cousin, or even yourself or your spouse.
Risk No. 5: Paying 529 Money on Non-Qualified Expenses
If you need to withdraw money from a 529 savings plan for a purpose other than qualified education expenses—such as a financial emergency of some kind—you can do that. But it will cost you. Your withdrawal will be subject to income taxes plus a 10% federal tax penalty. In addition, you’ll be expected to repay any state tax deductions that you took based on those contributions.
This is one of the many reasons why it’s a good idea for families to build a separate emergency fund, just in case.
FAQs
What Is the Difference Between a 529 Savings Plan and a Prepaid Tuition Plan?
The basic difference between a 529 education savings plan and a prepaid tuition plan is that the savings plan can be used at any school, while the prepaid plan offers the most benefit if it is used at a particular school. Both plans have similar tax benefits.
What Are the Tax Benefits of a 529 Plan?
In many states, you’ll get a tax deduction or credit if you contribute to a 529 plan. Your money will grow tax deferred and your withdrawals will be tax free, including on your federal income taxes, if you use the money for qualified education expenses.
Which Type of 529 Plan Is Best?
Most people will find that a 529 savings plan offers them more flexibility than a prepaid tuition plan.
What happens to the money in my 529 plan if my child doesn’t go to college?
You will have several options. One is just to withdraw the money and pay taxes on it. Another is to leave the money in the account for a time, in case your child changes their mind. A third is to change the account beneficiary to a sibling or other close family member.
The Bottom Line
While tax-advantaged 529 savings and prepaid tuition plans have their risks, they’re hard to beat as a way to save for a child’s education.