As you’ve probably gathered, college is expensive—if you want your kid to attend a university or vocational school, the sooner you can start saving for it, the better. To do so, you’ll want to consider saving into an education-based investment known as a 529 plan.
How a 529 plan works
Named after the IRS code they fall under, 529 savings plans are designed to be spent on tuition and other education expenses at any elementary, secondary, religious, vocational, or other post-secondary educational institution (and some eligible schools overseas, too). Like other types of long-term investment accounts, you put money aside and watch it grow with compound interest until you’re ready to withdraw (you have to be 18 years of age or older to invest in this plan).
The main benefit of a 529 plan is that while contributions are taxed upfront, the earnings will grow tax-deferred over time, similar to a Roth IRA. Another big advantage is that withdrawals made for qualified educational expenses (like tuition, laptops for class, student housing) will not be taxed federally—and, in many cases, they’re free of state tax, too. You can look up your state’s deduction policy here. The overall potential income tax savings in some cases could be roughly 30% of your withdrawal amount, depending on the state where you live.
Unlike other types of investment accounts, these plans are state-sponsored, which means your plan’s options can vary based on the state in which you open the account. Some states offer a variety of plans to choose from, too, which you can look up by state here. (If you want to avoid the hassle, you can also work with a financial advisor to choose a plan, for a fee).
There are two types of plans
There are two general types of 529 plans: prepaid plans and investment plans (states are allowed to offer both, although some don’t).
With a prepaid plan, you pay for a year of tuition or course units in advance and lock in a rate. You’re basically paying now to avoid any cost increases in the future. The downside is that these plans can be restricted to schools that are in-state.
With an investment plan, you choose how to invest the money you save. You still have to use it for educational expenses, but you’re not locked into specific tuition rates or college units the way you would be with a prepaid plan. For that reason, most experts suggest going with the investment plan.
Most 529 investment plans come with options for age-based or custom plans. With a custom plan, you choose how to divvy up or adjust your portfolio as you see fit. With an age-based plan, your portfolio mix automatically adjusts as the beneficiary gets closer to college-age. These plans start with a high percentage invested in stocks (e.g., 80-100% invested in stocks) before shifting over time to a lower percentage (e.g., 10-20%). The idea is to maximize growth early, then minimize the exposure to risk as you get closer to an expected withdrawal.
How to open a 529 plan
Before you open your 529 plan, decide on the state. The state that sponsors your plan also doesn’t require the school to be in-state (although prepaid plans can be the exception to this rule), so students can use the money to attend a qualified school elsewhere.
Use this tool to shop around and compare your state’s plans with other states, including fees and investment options. Vanguard also has a state tax calculator that can tell you exactly how much your potential tax benefit is worth.
Before picking your plan, read their program disclosure statement to make sure you’re familiar with all the rules and terms. In other words, read the fine print so you know what you’re getting into.
When enrolling, you’ll need to name an account owner (aka “participant”), which is probably yourself. Not many 529 plans allow for joint ownership, but relatives and non-relatives can always gift into a 529 account.
You’ll also have to name a beneficiary: the person receiving the money for college (your child, presumably). Keep in mind, it’s the owner, not the beneficiary, who controls the assets in the 529. From there, you can usually link your checking or savings account to your 529 account to make regular, automatic contributions.
Other rules you should know about
Unlike other tax-advantaged accounts, 529 plans do not have specific contribution limits set by the IRS. Most states do set limits between $350,000 and $500,000, however, per Nerdwallet.
Maybe more notable is the gift tax consequence: As the IRS explains, if your yearly contribution to the 529 plan (along with any other gifts) exceeds $15,000, you might have to pay a gift tax. (There is a way around it though, through a process known as superfunding).
Also, it’s pretty easy to change the beneficiary on your 529 plan. If your kid gets a scholarship and doesn’t need all the money you’ve invested over the years, you could easily change the beneficiary to a sibling.
A 529 plan is a great way to cover skyrocketing education costs, but make sure you spend money on qualified educational expenses, otherwise your withdrawal amount will be subjected to income taxes, along with an additional 10% tax penalty.
This post was originally published in 2017 and was updated on December 30, 2020 to reflect changes to 529 plans, update links, and to align with Lifehacker’s style guidelines.