As the cost of education continues to climb, planning ahead can help reduce the financial strain. A 529 plan, is a tax-advantaged savings plan specifically designed to encourage saving for higher education. This article will explore what a 529 plan is, highlight its benefits, touch on some potential drawbacks, and ultimately help you determine if this savings vehicle aligns with your financial goals.

What Is a 529 Plan?

A 529 plan is a tax-advantaged savings account aimed at covering qualified education expenses. Originally developed to cover college expenses, 529 plans have since expanded to include certain K-12 expenses (depending on the state), student loan repayment, and, under recent Secure Act 2.0 provisions, Roth IRA rollovers in specific situations (stay tuned for our upcoming article on 529-to-Roth Rollovers for more on this exciting update).

529 Plans offer tax free growth on withdrawals as long as they’re used for qualified education expenses. Account owners can choose from a range of investment options, such as mutual funds or age-based portfolios.

Key Benefits of 529 Plans

1. Tax Benefits
One of the primary advantages of a 529 plan is its tax treatment. Earnings grow tax deferred, and withdrawals on these earnings are tax free as long as they’re used for qualified education expenses. In addition, over 30 states offer state income tax deductions or credits for contributions, giving additional tax benefits for many savers.

2. High Contribution Limits
529 plan contributions qualify for the annual gift tax exclusion, which is $18,000 per person. This means each spouse can contribute $18,000 per year to each beneficiary for a total of $36,000 in 2024. Some may decide to take advantage of super funding the plan, in which up to five years’ worth of contributions can be made at once ($90,000 per person to each recipient). These high limits make 529s an attractive option for families aiming to save substantially over time.

3. Minimal Impact on Financial Aid
529 plans generally have favorable treatment in financial aid calculations. For example, when a parent owns a 529 plan, it’s counted as a parental asset, which has a relatively small effect on financial aid eligibility. For a grandparent-owned 529, distributions aren’t counted as income on the FAFSA, which can further benefit aid eligibility. This is great news for grandparents planning to support higher education costs for their grandchildren (stay tuned for our upcoming article on the Benefits of Grandparent-Owned 529 Plans for more details).

4. Flexibility and Control
Account owners have complete control over the account, even after the beneficiary reaches college age. If one child doesn’t use all the funds in the 529, owners can change the beneficiary of this plan to another child, other family member, or use it for themselves for qualified education costs.

5. Easy to Open and Manage
A 529 plan can be easily opened online or through a financial advisor. Many plans offer target date investment options that adjust based on the beneficiary’s age, gradually shifting from more aggressive to conservative investments as college age approaches.

Potential Drawbacks of 529 Plans

1. Penalties on Non-Qualified Withdrawals
Withdrawals not used for qualified education expenses will incur income tax on earnings and a 10% penalty. However, exceptions are available if the beneficiary receives a scholarship or attends a U.S. military academy, in which case penalties may be reduced.

2. Limited Investment Options
Unlike brokerage accounts, which offer a wide range of investment choices, 529 plan investment options are generally limited to a menu provided by the state or institution.

3. Fees and Costs
The cost of a 529 plan varies by state and plan type. Fees can include annual maintenance charges, enrollment costs, and management expenses. It’s essential to compare fees and choose a plan with reasonable costs to maximize your investment’s growth potential.

4. Residency Rules and State Limitations
While you can invest in any state’s 529 plan, many states require residency to receive certain tax benefits. Be sure to evaluate both in-state and out-of-state options to find the plan that best suits your needs, as some out-of-state plans may offer better investment choices or lower fees, despite the lack of state tax incentives.

Is a 529 Plan Right for You?

For families prioritizing education savings, a 529 plan provides favorable tax advantages and flexibility that can make a significant impact on college affordability.

Whether you’re beginning to save for a newborn’s future education or reallocating investments for an older child, a 529 plan can be a valuable component of a long-term financial strategy. Plus, with recent Secure Act 2.0 enhancements that allow unspent 529 funds to be rolled over into a Roth IRA (see specific rules), families have more options than ever before for putting their savings to work.