A Primer on 529 Plan Benefits

529 plans offer unmatched tax benefits

As you invest in any 529 plan, your earnings grow tax-exempt. Furthermore, you’re allowed to withdraw your money tax-free if you use the funds on qualified education expenses. These include the following:

• Tuition
• Mandatory fees
• Books and supplies required to take courses
• Electronic equipment and Internet access needed for enrollment
• Room and board that doesn’t exceed published estimated costs of on-campus housing
• Special needs equipment necessary for attending classes

But the tax benefits don’t stop there.

Most states offer 529 plan tax breaks

Several states allow you to make tax-deductible contributions or receive tax credits up to certain limits. More than 30 states, including the District of Columbia, currently offer such perks.

Most states allow above-the-line tax deductions when it comes to 529 plans. This means you deduct the contributions before determining your state taxable income.

Several states also allow you to carry forward excess contributions into the next tax year. So let’s say your state lets you deduct contributions up to $5,000 with a two-year carry forward. You contribute $7,000 one year. As a result, you can claim only $5,000 as a state tax deduction for that tax year. However, you can factor the difference or $2,000 into tax-deductible contributions for the next two years even if you didn’t make any contributions in that time frame.

The table below illustrates which states allow tax-deductible contributions and to what extent. Each deduction or limit for a credit listed below reflects what married joint filers can claim. Single filers may claim half the amount unless otherwise stated.

529 plan benefits deliver in a big way on taxes. But you may run into some trouble with the IRS if you use the money on nonqualified expenses. The IRS levies federal income tax and a 10% penalty on nonqualified withdrawals. Some states may require you to pay back previously claimed tax deductions.

Reach out to a CPA or CFP to discuss tax implications of a nonqualified withdrawal. Your advisor should also recommend alternatives.

But as long as you use your savings on qualified expenses, you can enjoy all the 529 plan benefits including the following:

Most 529 plans carry low fees

Several 529 plan investment options charge only a total annual asset-based fee. But don’t worry. These aren’t charged out of pocket. Instead, they’re removed from your account based on the program management costs and fund-related expenses. Still, these fees usually dip very low to about 0.28% across plans.

529 plans are easy to manage

You don’t need to know anything about investing to manage a 529 plan. In fact, a lot of the work is done for you. Most plans offer hands-off investment options called age-based portfolios.

These automatically change their asset allocation, or the mix of bond and stock funds they invest in. As your child gets closer to college age, these portfolios aim to drive the bulk of your money toward less risky investments.

In addition, most plans allow you to make automatic contributions by linking your banking or savings account. Several plans don’t even require a minimum contribution. But you can open most accounts with as little as a $25 deposit.

529 plans can fund more than just college

When most people think of college courses, they conjure up images of huge halls and kids scribbling notes. However, you can use your 529 plan money to study in a hands-on field at a technical school. Indeed, 529 plan benefits will cover your child’s education to become an auto mechanic.

529 plans fund qualified expenses at any school that participates in a financial aid program managed by the United States Department of Education. That umbrella covers four-year universities, community colleges, trade schools, technical schools and even culinary schools. Those who expect their children to broaden their horizons can even use the 529 plan money at certain foreign institutions.

Furthermore, the Tax Cuts and Jobs Act expanded 529 plan benefits. You can now use 529 plan money in part to fund private, public or religious K-12 schools. The law allows you to use up to $10,000 to pay tuition at such an institution per beneficiary, per year.

You can use 529 plans with scholarships

You don’t need to revoke your savings if your child gets a partial scholarship. Instead, you should use your 529 plan funds to reduce your college costs all the more. So feel free to search the top five places to find partial scholarships.

But in the event your child receives a full-ride scholarship, don’t feel as if you’re giving up all of your 529 plan benefits. You can still use the money to fund another family member’s education. Furthermore, the IRS allows you to make a penalty-free nonqualified withdrawal in the amount equal to the tax-free scholarship. However, you may still owe federal and state income tax on the withdrawal. Consult your financial advisor to discuss the tax implications of this move.

529 plans lightly affect financial aid eligibility

Your 529 plan assets affect your child’s financial aid eligibility to a small degree if you’re the custodial parent and account holder. In this case, the federal government counts only up to 5.64% of the account’s value into the student’s Expected Family Contribution (EFC). This formula determines a student’s federal financial aid eligibility.

But if the student serves as the account owner, the government factors a larger cut of up to 20% into the EFC.

If the account owner is someone else such as an uncle or a grandparent, the plan won’t count as an asset. However, withdrawals from the plan to cover the student’s education will count as the student’s untaxed income when he or she fills out future Free Application for Federal Student Aid (FAFSA) forms.

The federal government treats assets and income differently when calculating a student’s eligibility for financial aid.

But the general rule of thumb dictates a custodial parent should open the 529 plan account in order for a child to make the most out of potential financial aid packages.

529 plans permit large contribution limits

Each state sets its own 529 plan contribution limit. These peaks typically range from about $200,000 to more than $500,000. If you’re worried about setting off a gift tax, 529 plans offer some wiggle room.

In fact, for the 2023 tax year you can contribute up to $85,000 ($170,000 if married filing jointly) into a 529 plan all at once. That amount climbs past the 2023 $17,000 gift-tax exclusion. However, the IRS waives gift tax if you don’t make any more contributions for five years.

Overall, 529 plans offer several ways to give money to students while avoiding gift tax.

Anyone can open a 529 plan

Anyone 18 or older with a valid Social Security or tax identification number can open a 529 plan. No rules restrict you to opening a 529 plan sponsored by your own state. You can shop around to see which plan offers the 529 plan benefits that appeal to you.

You can even open a 529 plan to fund your own education. Those expecting children can start saving right away by naming themselves as beneficiaries. Then, they can designate their children as the beneficiaries after they’re born.

529 plans take donations

Your friends and family can contribute toward your 529 plan. Some plans facilitate the process by providing you with a link you can email and share on social media to maximize your savings potential. Some states even allow others to make tax-deductible contributions into your 529 plan.

529 plans don’t expire

Say your child decides not to go to school or takes some time off. Don’t fret. Your money stays in the plan. Your child can use it when he or she feels ready. You can also change beneficiaries to someone in the child’s immediate family without penalty. If you’re using a prepaid tuition plan, they typically have a 30-year limit.

How do you open a 529 plan?

Now that you know all about the 529 plan benefits, you may be concerned about the process. Don’t worry. Most plans let you enroll online in as little as 15 minutes. Just make sure you have the following information about yourself and your beneficiary ready.

• Social Security or tax identification numbers
• Birthdates
• Addresses

You should also have your bank account and routing numbers ready if you’re making an initial contribution electronically. But most plans accept checks as well. And remember, you’re not limited to investing in your own state’s 529 plan. No rules limit you to investing in just one plan either.

You can open a portfolio-based 529 plan account, while contributing toward a prepaid college tuition savings plan. So shop around. We’ve reviewed the 529 plan benefits, fees and other features of options across the country. A financial advisor can also help you create your own savings strategy utilizing one or more 529 plans based on your individual goals.

Bottom line

529 plan benefits extend beyond tax breaks. You can open an account sponsored by any state regardless of residence. Any scholarship and financial aid money your child earns can combine with your 529 plan savings to cut down the cost of college even further.

In fact, you don’t even need to use your funds at a traditional college. Your child can use them at trade or technical school and more. And opening a 529 plan is as easy as a few mouse clicks.

Anyone thinking about ways to save for college should consider opening one.

Javier Simon, CEPF® is a banking, investing and retirement expert for SmartAsset. The personal finance writer's work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society for Advancing Business Editing and Writing. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children's Miracle Network Hospitals and the National Center for Missing and Exploited Children.

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