529 College Savings Plans Explained: How They Work and What They Cover

A 529 plan can help your education savings grow with tax breaks, as long as you understand the rules before you start.

If you are a parent thinking about how to pay for your child's education, you have probably heard of a 529 plan. The name comes from Section 529 of the federal tax code, which created these accounts. The IRS describes a 529 plan, also called a qualified tuition program, as a plan run by a state or an educational institution that comes with tax advantages for education costs.

This guide explains how 529 plans work in plain English. It does not list yearly limits, because those can change. When a number matters, check irs.gov or your state's plan website for the current figure.

The two types of 529 plans

There are two basic kinds of 529 plans.

1. Education savings plans. This is the most common type. You put money into an account and choose how to invest it, often from a menu of mutual funds or similar options. Many plans offer age-based portfolios, which start out more growth-focused and shift toward more conservative investments as the child gets closer to college. The SEC's Investor.gov notes that these investments are not federally guaranteed and can lose value.

2. Prepaid tuition plans. These let you buy units or credits at today's prices to use for future tuition at participating schools, often in-state public colleges. Some states back these plans and some do not. If your child attends a school outside the plan, the payout may be smaller than you hoped.

According to Investor.gov, all 50 states and the District of Columbia sponsor at least one type of 529 plan, and a group of private colleges and universities sponsors a prepaid tuition plan.

How the tax breaks work

The main appeal of a 529 plan is how it is taxed. Here is the basic picture from the IRS:

• Contributions are not deductible on your federal return. You put in money you have already paid tax on.
• Earnings grow without federal tax while they stay in the account.
• Withdrawals are tax-free when the money is used for qualified education expenses.

Many states add their own perk, such as a state income tax deduction or credit for contributions. Investor.gov notes that a state tax deduction often applies only if you use your own state's plan. You are generally free to choose another state's plan, which may make sense if its fees are lower. Compare both before deciding.

What counts as a qualified expense

"Qualified expenses" is the key phrase. Money used for these costs comes out tax-free. According to IRS guidance, qualified higher education expenses include:

• Tuition and required fees at eligible colleges, universities, vocational schools and other eligible schools
• Books, supplies and equipment needed for enrollment
• Computers and related technology used for school, in many cases
• Room and board for students enrolled at least half-time

The rules also allow some other uses:

• K-12 expenses. A limited amount per year can be used for elementary and secondary school costs, such as tuition. The IRS sets the annual limit, so check irs.gov for the current amount.
• Registered apprenticeships. Fees, books, supplies and equipment for a registered apprenticeship program can qualify.
• Student loans. A limited lifetime amount can go toward paying principal or interest on qualified student loans for the beneficiary or a sibling.

Keep receipts that show what each withdrawal paid for. Your plan will send a Form 1099-Q that reports what you took out, including how much was earnings.

What if the money is not used for school?

Plans change. A child may get a scholarship, choose a different path or not need all the money. You have options.

Change the beneficiary. The beneficiary is the person the account is for. IRS Publication 970 explains that you can generally switch the beneficiary to another qualifying family member, such as a sibling, without tax.

Roll some into a Roth IRA. Under federal rules, money from a 529 can be moved into a Roth IRA for the beneficiary, within limits. The IRS says the 529 account must have been open for at least 15 years, the move must be a direct transfer, it counts toward the yearly Roth IRA contribution limit, there is a lifetime cap and money contributed in the last five years does not qualify. Check irs.gov for the current rules before trying this.

Take a non-qualified withdrawal. If you take money out for something that is not a qualified expense, the earnings part of the withdrawal is taxed as income. The IRS also adds a 10% additional tax on that taxable part. Your original contributions are not taxed again.

There are exceptions to the 10% additional tax, according to IRS Publication 970. These include the death or disability of the beneficiary and the beneficiary receiving a tax-free scholarship. The details matter, so read the exceptions in Publication 970 or ask a tax professional before taking money out.

Things to check before you open a 529

Every state plan is different. Consider these questions:

• What are the fees? Look for enrollment fees, yearly account fees and investment expenses. Plans you buy directly from the plan, rather than through a broker, may avoid broker fees.
• What tax break does your state offer? And does it require using your state's plan?
• What investment choices are there? Look at age-based options and how much they cost.
• Who controls the account? The account owner, often a parent, makes the decisions, not the child.
• How might it affect financial aid? Investor.gov notes that 529 savings may reduce need-based aid. Since many aid packages lean on loans, though, savings can still lower how much your child has to borrow.

Anyone can open a 529 plan for a child, including grandparents, aunts and uncles or family friends. The IRS notes there are no income limits for contributors. Large gifts can have gift tax rules, so check irs.gov or talk with a tax professional if you plan to put in a lot at once.

Getting started

You do not need a big lump sum to begin. Many plans let you start small and set up automatic monthly contributions. Relatives may be able to give to the account for birthdays or holidays, too.

To compare plans, visit your state's official 529 plan website and read the plan's disclosure document, sometimes called a program description. For federal tax rules, start with IRS Topic 313 and Publication 970 on irs.gov.

This article is for education only and is not financial advice. Everyone's situation is different.