What is a 529 Plan and How to Use It


Saving for college is no easy task. According to US News, the average tuition and fees for 2020-2021 is:

  • $9,687 for public, in-state,
  • $21,184 for public, out-of-state
  • $35,087 for private

This does not include housing, food, or books. 

With the rising cost of tuition, there is about $1.6 trillion in federal and private student loan debt as of June 2020. Although loans are often a good resource, if you have the ability to save, 529 plans can be helpful. 

For parents, grandparents, or family members looking to save money for kids, a 529 plan is an excellent way to prepare for future costs. 

In this post, you’ll learn what is a 529 plan, the features, tax benefits, how to use the plan, what happens if you have money leftover, how to choose a plan, and guidance about how to select the investments in the plan. 

Features and Tax Benefits

There are two main types of 529 plans:

  • Prepaid Tuition Plans
  • College Savings Plans

Prepaid tuition plans are exactly what they sound like. With this type of plan, you purchase credits at participating colleges at current prices for future use. 

For example, in Washington State, we have the GET program, or Guaranteed Education Tuition. The GET account is guaranteed to keep pace with tuition and state-mandated fees at Washington’s highest-priced public university. Unlike a college savings plan that fluctuates with the stock and bond market, every 100 units in GET equals the cost of one year resident, undergraduate tuition and state-mandated fees at Washington’s highest-priced public university. Units can be bought in whole or partial amounts. 

The upside to these plans is you are locking in the cost of tuition. The downside is the account likely won’t grow much because in Washington state, after years of tuition rising much faster than inflation, the law changed where tuition cannot increase by more than the average annual percentage growth rate in the median hourly wage for Washington for the previous fourteen years. This historically has been low. 

If your child attends school in-state, it is not an issue because the plan pays for in-state school no matter the cost; however, if they use the plan to attend a college out of state, the lower growth tied to the hourly wage increase means the GET unit values may not increase at the same pace as tuition increases elsewhere.

College Savings Plans are similar to investment accounts, such as a Roth IRA. You contribute after-tax money to the account, the earnings grow tax-free, and withdrawals for qualified educational expenses are tax-free. Unlike the prepaid tuition plans, your account value will fluctuate in value based upon the investments you select. Although it comes with more risk than a prepaid tuition plan, it can also come with more rewards. 

In addition to using the plans for college, you can also withdraw $10,000 per year for tuition at private elementary and high schools. You can also withdraw $10,000 once per lifetime per beneficiary to pay down student loans. For example, if you have two plans for the same beneficiary and you withdrew $10,000 to pay down student loans already, you cannot use the other plan to pay down student loans. 

Income Tax Benefits

For those living in states with income taxes, 529 plans can offer income tax benefits for contributions to the state plan. Since I live in Washington state, where we do not have an income tax, this does not matter in the decision about which state plan to choose. There will be more on this later. Please feel free to skip ahead if that is of interest. 

However, our neighbors to the south in Oregon are eligible for income tax deductions to their state plan. For example, joint filers can earn up to $300 and single filers can earn up to $150 for contributions to the Oregon College Savings Plan. The amount you need to contribute to earn the maximum credit depends on your adjusted gross income (AGI).  

If you go farther south to California, though they have an income tax, they do not receive a tax deduction for contributions to their 529 plans. Like Washington state, the income tax deduction does not factor into their decision about which plan to choose. 

If you live in a state with a tax deduction for contributions to a 529 plan, but the plan is otherwise not very good (high fees, limited investment options, etc.), it may make sense to contribute enough to get a deduction and open a second 529 plan in another state with lower costs and better investment options. 

Gift Limits 

Another benefit of a 529 plan is the gifting limit. The annual gift tax exclusion amount is $15,000, which is the amount any person can give any other person each year without needing to report it. Although no tax is due, there are reporting requirements. Amounts above $15,000 require a gift tax return and go against your lifetime gift and federal estate tax exemption. 

529 plans allow you to contribute 5 years worth of contributions, or $75,000 total, in one year and have it count as if it were made over the five calendar years for gift tax exclusion purposes. This is particularly helpful if you receive a large bonus or have a grandparent wanting to contribute to the plan in a large lump sum. They could contribute $75,000 to a 529 plan and make the five-year election by filing a gift tax return and completing Form 709. 

If someone wants to contribute less than $75,000, they can. For example, if they contributed $50,000, they would still make the five-year election, which means $10,000 per year would be applied, leaving $5,000 per year in an unused annual exclusion amount. They could still gift $5,000 per year to the beneficiary. 

Although contribution limits vary by each state plan, you should be aware that each state only accepts contributions up until a certain amount, typically $300,000-$500,000. 

Who Should Own the Plan?

Child playing with bubble

One of the most common questions is who should own the plan? Should it be a parent or grandparent?

Like most financial planning, the answer is “it depends.” 

The account owner retains control over the account, meaning they can change the beneficiary, control distributions, and adjust the investments. 

This is important to keep in mind because it depends how much control you want someone to have. For someone who wants total control, they should own the plan. A parent could open a 529 plan and have a grandparent contribute to it. Or, vice versa. Anybody can contribute to anyone’s 529 plan. 

However, from a planning and financial aid perspective, a parent and grandparent owned 529 plan are treated very differently.

A parent-owned 529 plan is reported on the FAFSA and can reduce eligibility for need-based aid by 5.64% of the 529 plan value. 

A grandparent-owned 529 plan is not reported on the FAFSA, but distributions from it are counted as income to the student and affect the expected family contribution (EFC). The expected family contribution can increase by 50% for distributions. For example, if a grandparent makes a $20,000 distribution to a grandchild, the EFC could increase by $10,000 for the following year. 

To optimize financial aid, grandparent-owned 529 plans should generally not make distributions until the last two years of college because the FAFSA has a 2-year look back period. By delaying distributions until after January 1 of the student’s sophomore year, the distribution will not impact need-based aid. Please keep in mind that if the student decides to go to graduate school, you may want to delay distributions from the grandparent-owned 529 plan longer. 

If the student needs funds earlier, the grandparents can change the account owner to the parent or rollover a partial amount to a parent-owned 529 plan. 

While I talked about the FAFSA, some colleges use the CSS to determine aid eligibility, which looks at 529 plans similarly regardless of who owns them. This means there is less planning that can be done to increase your aid eligibility.

529 plans are an excellent way to save for college. They offer flexibility and many tax benefits. With the proper planning and discussions with family members, you can make the most of them for financial aid purposes. 

Qualified Educational Expenses

Now that you know more about their benefits, you should know what qualifies for tax-free distributions from a 529 plan. 

As stated earlier, you can take tax-free withdrawals up to $10,000 per year per beneficiary to pay for private elementary or high school tuition, as well as up to $10,000 once per lifetime per beneficiary to pay down student loans. 

You can also use it for college expenses. More specifically, you can take tax-free withdrawals for the following:

  • Tuitions and fees
  • Books and supplies
  • Room and board
  • Computers

One of the most common questions is whether they can be used for housing off campus. The answer is yes, but subject to a limit. You cannot take a tax-free withdrawal in excess of what the school sets as the allowance for room and board. You can find this by looking at the school’s cost of attendance for federal financial aid calculations. 

Be sure to keep receipts for spending in case the IRS ever wants to see them. 

What are common expenses not eligible for tax-free withdrawals?

  • Travel costs, such as gas and airfare  
  • Health insurance
  • Extracurricular fees
  • College application fees

If you take a distribution for a non-qualified educational expenses, the earnings may be subject to ordinary income tax and a 10% penalty. 

Leftover Money

Some children receive scholarships and others choose not to attend college. Sometimes families overfund their 529 plans. 

If you have leftover money in a 529 plan, there are a few options:

  • Save it for a graduate degree
  • Change the beneficiary or roll funds to another child 
  • Distribute the money 

If your child earned a scholarship, there is an exception to the 10% penalty previously mentioned. You can take a distribution up to the amount of the scholarship and avoid the 10% penalty; however, you will still pay ordinary income tax on the earnings. 

While many people start a 529 plan with an undergraduate degree in mind, they can also be used for post-secondary degrees. If your child graduates with an undergraduate degree and may want to return for a graduate degree in the future, you can leave the money in the 529 plan. 

Another option is rolling funds to another child. For example, if you have two children, you can roll funds from the older child’s 529 plan to the younger child’s 529 plan for their college. 

You can also change the beneficiary of the account. The IRS provides specific guidelines about who you can change the beneficiary to without tax consequences. Below is a list of the people you can change the beneficiary to: 

  1. Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.
  2. Brother, sister, stepbrother, or stepsister.
  3. Father or mother or ancestor of either.
  4. Stepfather or stepmother.
  5. Son or daughter of a brother or sister.
  6. Brother or sister of father or mother.
  7. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
  8. The spouse of any individual listed above.
  9. First cousin.

The last option is distributing the 529 plan. If your child, sibling, eligible family member, or you are unlikely to go back to school, you can distribute the funds and pay a 10% penalty and ordinary income tax on the earnings. 

Selecting a Plan

Although every state offers a 529 plan, you do not need to choose your state’s plan. You can choose any 529 plan you want. 

As I discussed earlier, you normally want to strongly consider your state’s plan if it provides an income tax deduction. 

If your state plan is not very cost effective or you do not receive an income tax deduction, you have many options. Morningstar produces a list of the top 529 plan college savings plans each year.  

I personally use the my529 plan, which is sponsored by Utah, and love it. The plan is low cost, has great investment options, and the website is easy to navigate. The administrative asset fee ranges from 0.10% to 0.15%, includes Vanguard and Dimensional Fund Advisor funds, and provides a link you can send family members if they want to contribute to the account. 

My529 plan homepage - what is a 529 plan

As you evaluate plans, make note of the following aspects:

  • Administrative fees
  • Investment funds and their fees
  • Minimum account sizes
  • Ease of use

Plans can change over time. If the my529 plan is not as competitive as other plans in the future, I will likely open a new 529 plan and roll the funds from my529 into it. 

Choosing Investments

Although some plans are prepaid tuition plans without stock market risk, most people will likely be dealing with a plan where your investment will be invested in stocks and bonds. 

As with any investment, you need to select a mix of stocks and bonds that aligns with your intended time frame for using the money.

For example, if you start a plan when your child is born and have 18 years for it to grow, you likely are okay taking more risk and investing more heavily in stocks. However, if your child is age 18 and starting college next year, you likely should have very little, if any, money invested in stocks. 

Within plans, they usually allow you to choose an age-based portfolio or a custom static option. The age-based portfolio automatically adjusts as your child gets older. For example, it may start as 100% stocks and reduce the stock exposure as your child ages. These are helpful investments if you want a “set it and forget it” option. I like these options because I know most people will set their 529 plan investments once and rarely come back to it. Below is an image of my529 plan’s age-based aggressive global portfolio. 

Age-based aggressive global glide path
allocation table for age-based aggressible global

The other option is a custom static portfolio, which means you select which funds and how much is invested in each one. While I personally invest this way, it’s not for everybody. Many people I talk with set their 529 plan allocation and forget about it. This generally works in their favor because markets generally increase over time, but this can be a huge issue if they set an aggressive allocation, forget about it, and the market crashes right before their child goes to college.

I only advocate investing this way if you make an annual commitment to revisit the investment allocation and make it more conservative as your child gets older. It would be a terrible thing if you had enough in your 529 plan to pay for 100% of college when your child is age 17, left the account invested in 100% stocks, and the market crashed 30-50% the next year. 

As I have said before, each person’s situation is unique. I am speaking in generalities about how I would think about investing the money in a 529 plan. For example, the money I have in a 529 plan won’t be used for 15+ years and I am very comfortable with stock market risk. As a result, the money in my 529 plan is invested 100% in stocks. 

Summary – Final Thoughts

With the rising costs of college, creating a strategy around paying for college is critical. Most strategies should include using a 529 plan. There are many tax benefits and features that make it attractive. 

From the five year gift election to who should own the plan, there are many ways to take advantage of what a 529 plan offers. Although tax-free withdrawals can only be used for qualified educational expenses, there are many ways to use leftover money in a 529 plan. 

With over 50 plans to choose from, carefully analyze what makes the most sense for you and how to invest it given your child’s age. 

I wish you the best in planning for college. 

Disclaimer: This article is for general information and educational purposes only and should not be considered investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change. Click for Full Disclaimer