What to know about 529 college savings plans

Key points

• 529 plans provide significant tax breaks when used to pay for a child’s college education.
• Many states offer a state income tax deduction or tax credit based on contributions to the state’s 529 plan.
• 529 plans are treated favorably by financial aid formulas.
• Choose a 529 plan by considering the net return on investment after subtracting fees.

529 college savings plans are the most popular way of saving for a child’s college education. They offer significant tax benefits and are treated favorably by financial aid forms (money in a 529 plan has a smaller impact on financial aid than assets in the child’s name). They are also more flexible than other options for saving for college, such as prepaid tuition plans and Coverdell education savings accounts.

529 college savings plans, also known as 529 plans, are specialized savings accounts that offer tax and financial aid advantages when used to save for a college education.

It is best to start saving for college when a child is born, since that gives more time for the earnings to compound, but it is never too late to start saving for college. Every dollar you save is a dollar less you’ll have to borrow.

Who controls a 529 college savings plan account?

A 529 plan has only one beneficiary and only one account owner.

You, the parent, are the account owner and you control the account, not the beneficiary. The account owner continues to control the account even after the beneficiary reaches the age of majority, unlike custodial bank and brokerage accounts.

You can change the beneficiary of the account to a member of the family of the old beneficiary if, say, the child on the account does not need the funds to pay for school. Members of the family include:

• Children, stepchildren, foster children, adopted children and their descendants.
• Brothers, sisters, stepbrothers and stepsisters.
• Parents, stepparents and their ancestors.
• Aunts, uncles, nieces, nephews and first cousins.
• Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law and sister-in-law.
• The spouse of a member of the family.

The only exception is a custodial 529 plan account, where the child is both beneficiary and account owner. If the child is underage, there will need to be an adult custodian to manage the account on behalf of the child. The custodian cannot, however, change the beneficiary of a custodial 529 plan account.

How to choose a 529 plan

You can open a 529 plan in almost any state. Except for a handful of state 529 plans, you do not need to be a state resident to open a 529 plan in the state. A 529 plan can be used to pay for college costs in any state.

Most states offer a direct-sold 529 plan, where the money is invested directly from the state. Many states also offer one or more advisor-sold 529 plans, where the money is invested through an independent investment advisor.

Families should consider performance, cost and tax breaks when choosing a 529 plan.

This often translates into a trade-off between lower fees in an out-of-state 529 plan and state income tax breaks in an in-state 529 plan.

Generally, you should look for 529 plans with fees less than 1% and ideally less than 0.5%, since minimizing costs is the key to maximizing net returns.

Tip: Direct-sold 529 plans from states usually have lower fees than advisor-sold 529 plans.

You should consider your own state’s 529 plan if it offers a state income tax deduction or tax credit. Or look at the direct-sold 529 plans of states with low fees, such as:

• California
• Florida
• Illinois
• New York
• Pennsylvania
• Virginia
• West Virginia
• Wisconsin.

If you’re lucky, your state will offer both low fees and a state income tax break.

Low fees matter more when the child is young and state income tax breaks matter more when the child is older, because the fees are assessed on the entire portfolio while state income tax breaks are limited to just that year’s contributions. The inflection point occurs around when the child enrolls in high school.

Tax treatment of 529 plans

Contributions to a 529 plan are made with after-tax dollars.

Earnings accumulate on a tax-deferred basis and distributions are entirely tax-free if used to pay for qualified higher education expenses.

Two-thirds of states provide a state income tax credit or deduction based on contributions to the state’s 529 plan. The seven states below provide a state income tax break for contributions to any state’s 529 plan.

• Arizona
• Arkansas
• Kansas
• Minnesota
• Missouri
• Montana
• Pennsylvania

Rollovers to another 529 plan are tax-free at the federal level. Some states do not conform to the federal income tax treatment and treat an outbound rollover to an out-of-state 529 plan as a non-qualified distribution. An inbound rollover may be eligible for a state income tax break in some states, sometimes based on just the principal portion of the rollover, after subtracting the earnings from the amount of the rollover.

Impact of 529 plans on financial aid eligibility

On the Free Application for Federal Student Aid (FAFSA), parent assets reduce eligibility for need-based financial aid by as much as 5.64% of the asset value on the FAFSA. Student income (taxable or untaxed) reduces aid eligibility by as much as half of the distribution amount.

Generally, the money in a 529 plan is counted as the account owner’s asset on the FAFSA, and qualified distributions are ignored. That’s the case if a 529 plan is owned by a dependent student or a dependent student’s parent. If a 529 plan is owned by an independent student, it is reported as a student asset on the FAFSA and qualified distributions are also ignored.

However, if a 529 plan is owned by anybody else, such as a grandparent, aunt or uncle, it is not reported as an asset on the FAFSA, but qualified distributions are reported as untaxed income to the beneficiary. Note that starting with the 2024-25 FAFSA, the cash support question will be eliminated, so qualified distributions will no longer be reported as untaxed income.

If a dependent student’s parents are divorced and the 529 plan is owned by the non-custodial parent, it is treated the same as a grandparent-owned 529 plan.

How 529 contributions work

You can contribute to any 529 plan, even if you aren’t the account owner or beneficiary. For example, a grandparent can contribute to a grandchild’s 529 plan that is owned by the grandchild’s parent.

There are no annual contribution limits to 529 plans. There are also no age or income limits on contributions, unlike a Coverdell education savings account.

However, contributions may be subject to gift taxes. The annual gift tax exclusion is $17,000 per recipient in 2023 ($34,000 for gifts from a married couple). The gift is immediately removed from the contributor’s estate, and the account owner retains control over the account.

529 plans have a special rule called superfunding or five-year gift-tax averaging, which allows contributors to give a lump sum of up to five times the annual gift tax exclusion and have it treated as though it were given over a five-year period, starting with the year of the gift. If the contributor dies during the five-year period, the contribution is proportionately removed from the contributor’s estate.

There are maximum account, or aggregate, contribution limits, and they vary by state, from $235,000 in Georgia and Mississippi to $529,000 in California and $542,000 in New Hampshire. The average aggregate contribution limit is about $433,000. Once you reach the aggregate contribution limit, you cannot make any more contributions to the 529 plan. However, the 529 plan can continue to appreciate in value.

Most families do not need to save that much. Instead, they should aim to save about one-third of future college costs. This is roughly the same as the cost of a four-year college education the year the child was born. The rest of the money will come from financial aid, contributions from income when the child is enrolled in college, and a reasonable amount of student loan debt. Some families save more to reduce the need to borrow to pay for college, because it is cheaper to save than to borrow.

Tip: To achieve the one-third savings goal for college — which should be enough if you also count financial aid, your child’s contribution from work and some loans — will require saving $250 per month from birth for an in-state public four-year college, $450 per month for an out-of-state public four-year college and $600 per month for a private nonprofit four-year college for a child born in 2023.

To check whether your savings are on track to reach this goal, multiply the child’s age by $3,000 for an in-state public four-year college, $5,000 for an out-of-state public four-year college and $7,000 for a private nonprofit four-year college. Compare your college savings with this minimum threshold.

Minimum contributions of $15 or $25 to 529 plans are typical, especially with payroll deductions or automatic investment programs. An automatic investment program transfers money from your bank account to the 529 plan each month, so you don’t have to take any extra steps to save.

Many 529 plans offer gifting tools, which make it easy for friends and family to give the gift of college by contributing to a child’s 529 plan to celebrate the winter holidays, birthdays and graduation.

Investment options for 529 plans

Most 529 plans offer a few dozen stock and bond funds as investment options. These include mutual funds that invest in U.S. stocks, foreign stocks, real estate, bonds, money market accounts and cash.

All 529 plans offer an S&P 500 fund or total stock market fund. So, you can pick a mix of investments to create your own asset allocation.

Some funds are static, investing in a fixed asset allocation.

Other funds are dynamic, changing the mix of investments based on the child’s age or year in school. These are often called age-based asset allocations.

Qualified distributions

Distributions are tax-free if you use them to pay for qualified expenses at an eligible school.

Qualified higher education expenses include:

• Tuition.
• Fees.
• Course materials (books, supplies and equipment).
• Computers (including peripherals, software and internet access).
• Apprenticeship programs.
• Special needs expenses.
• Room and board (as long as the student is enrolled on at least a half-time basis).

Qualified expenses also include up to $10,000 in student loan repayment each for the beneficiary and the beneficiary’s siblings. If the account owner changes the beneficiary to the parent before taking a distribution, the 529 plan can also be used to repay up to $10,000 in parent loans. The $10,000 limit is a lifetime limit per borrower, not per 529 plan.

Up to $10,000 a year in elementary and secondary school tuition is a qualified expense.

Transportation, health insurance, healthcare costs, college admissions tests and test prep are not qualified expenses.

Eligible institutions include all colleges that are eligible for Title IV federal student aid. More than 6,000 U.S. colleges and about 400 foreign colleges have Title IV federal school codes.

There are no age or income limits on distributions from 529 plans.

Non-qualified distributions

If you take out money from a 529 plan for something that is not considered a qualified expense, you lose the tax advantages of the account, and could pay a penalty, too. The earnings portion of a non-qualified distribution is included in the adjusted gross income (AGI) of the recipient, so the recipient will pay taxes on it.

The earnings portion of a 529 plan distribution is assumed to be proportional. It is not possible to return just contributions. That means you don’t get to choose how much of the distribution is contributions and how much is earnings. If your 529 plan has two-thirds contributions and one-third earnings, then the distribution is two-thirds contributions and one-third earnings.

The recipient of a 529 plan distribution can be the beneficiary, the account owner or the school attended by the beneficiary. If the distribution is made directly to the school, it is treated as though it were made to the beneficiary.

The earnings portion of a non-qualified distribution is also subject to a 10% tax penalty.

Exceptions to the 10% tax penalty include distributions because of the following:

• The death or disability of the beneficiary.
• Receipt of a tax-free grant, scholarship or fellowship.
• Receipt of veterans’ educational assistance.
• Receipt of employer-provided educational assistance.
• Receipt of the American Opportunity Tax Credit or Lifetime Learning Tax Credit.
• Enrollment in a U.S. military academy.
• Receipt of other tax-free educational assistance.

The exception to the 10% tax penalty is limited to the extent of the qualified expenses corresponding to the educational assistance or benefits. For example, if you take a $2,500 non-qualified distribution and received a $1,000 scholarship, the 10% penalty is waived up to the amount of the $1,000 scholarship, not beyond.

Non-qualified distributions may also be subject to recapture of state income tax breaks attributable to the distribution.

If a student receives a refund of qualified higher education expenses from their college, they can recontribute the money to a 529 plan within 60 days to avoid having a non-qualified distribution. The recontribution can be to any 529 plan for which the student is the beneficiary, not just the 529 plan from which the distribution was made.

Options for leftover money in a 529 plan

There are several options if the beneficiary does not go to college or if there is leftover money after the beneficiary graduates.

• You, the account owner, can change the beneficiary to another member of the beneficiary’s family, such as a sibling or parent.
• You can keep the money in the 529 plan account, in case the beneficiary enrolls in college or graduate school later in life. 529 plan money can also be used for continuing education. The beneficiary does not need to be degree-seeking.
• The 529 plan can be used to pay for college for the beneficiary’s children, leaving a legacy for future generations.
• The money in a 529 plan can be rolled over into an ABLE account, up to the annual gift tax exclusion each year, to pay for special needs expenses of a disabled beneficiary.
• You can take a non-qualified distribution, payable either to the beneficiary or the account owner.