529 Plans: How to Get Started
Whether you child is 17 months or 17 years, chances are you've heard other parents talking about whether or not they use a 529 plan, and if so, how much they have saved in it for college. But a lot of parents and caregivers only have a foggy idea of how they work.
The big advantage of 529 plans is that they allow families to save for future college expenses while also getting some tax breaks. We've got a breakdown of the basics you need to select, open, and begin funding a 529 plan for your future college student.
Why should I have a 529 plan?
For most families, 529 plans are a great way to save money for college (or even some private elementary and secondary school expenses) while also getting some tax advantages. There are many 529 plans with different types of investments, fee structures, and tax benefits. We break down the basics of what you need to know below.
How much do 529 plans cost?
It varies, but most plans are relatively low cost. Each plan has different kinds of fees, depending on the kind of plan it is, whether it's sold directly or through an investment advisor, and more. The most common fees you'll see include:
Account opening or enrollment fees — a one-time fee when you open the account
Account or annual maintenance fee — may be charged monthly, quarterly, or annually; sometimes waived if you meet certain criteria such as setting up a recurring deposit, being a resident of the state the plan is sponsored by, or maintaining a certain balance
Sales or brokerage fees — this is essentially a commission, taken as a small percentage of your investment; only applies if you invest in a 529 plan via a broker
Expense ratio — charged by virtually every plan, this is a small percentage based on the funds in your account. If your plan with a .03 percent expense ratio, the plan will keep $30 for each $10,000 you have in the account. Broker- or advisor-sold funds tend to have higher expense ratios than funds that you can buy directly.
With the exception of the expense ratio, most of these fees will be fixed, and fairly small, usually $100 or less.
You'll find 529 plans also differ in how much you have to invest upfront (your initial deposit) and/or the minimum size of any recurring deposits you wish to make. When you're comparing plans, make sure to take this into account. If your initial plan is to invest $50 per month, a plan with a minimum deposit of $100 per transaction is going to be less than ideal.
One more thing: When comparing costs, don't forget to consider the value of any tax breaks you would get with a given plan. If Plan X's annual fees are $50 more per year than Plan Z, but Plan Z also saves you $500 yearly in your taxes, it's actually the cheaper plan for you.
How do these tax advantages in a 529 plan work?
The exact tax benefits you can glean from using a 529 plan depend on the plan you choose and the state you're in. In essence, there are two potential types of tax advantages you can get from using a 529 plan:
Your withdrawals — as long as money you pull from the account is used for qualified educational expenses (we explain that below) the earnings from the account aren't subject to federal taxes. And, in some states, they aren't subject to state taxes either. Over time, that can add up to significant savings. And the earlier you start saving, even tiny amounts, the more of a benefit you'll reap.
Your contributions — Depending on the rules in your state, you may have other tax benefits when making contributions to a 529 plan. Some states allow you to deduct those contributions from your state taxes or offer matching contributions and other benefits. Note: In most cases, to get those benefits, (especially the tax deduction) you need to be using a plan sponsored by the state you live in.
What can I pay for with a 529 plan?
Funds in your child’s 529 plan can be used for what IRS considers “qualified educational expenses.” That term covers a lot of ground. You can use these funds for many expenses including:
tuition and fees
books, supplies, and equipment including a computer and software
room and board for students enrolled at least half-time
expenses for special needs services.
That doesn't mean every expense you have can be paid for by 529 funds. IRS has rules about which fees/expenses count as "qualified." For example, expenses for room and board are allowed, but that doesn’t mean every dollar spent on rent is considered a “qualified” expense. The amount you can count toward your qualified expenses can’t be greater than either the costs charged for your student to live in school-owned housing or the allowance for room and board. That number is determined by the school for financial aid purposes and was included in the cost of attendance.
IRS’ rules have some gray areas and everyone has slightly different tax situations, so, a cost that might not be a qualified expense for one family might be for another. If you have a specific question, you can either check with your tax preparer or, check out IRS’ guide for specifics.
Note: If you use any 529 distributions for expenses that aren't qualified, you'll have to pay taxes on them — which means you lose the main benefit of using a 529 in the first place. So make sure you double check before taking any 529 distribution.
You can learn more about the rules and best strategies for withdrawing funds from a 529 plan here.
Which 529 plan is best for me?
When you start looking into 529 plans, don't be surprised if you feel dizzy. Every state and Washington DC sponsor at least one 529 plan. And within the umbrella term of "529 plan" there are actually two types: prepaid tuition plans and education savings plans.
Prepaid tuition plans essentially let the 529 account holder buy "credits" of tuition for future use — but at today's prices. The credits are good only at a specific, usually state-funded private school. If your student opts to go to a different college, you can still use the benefit, but the value is likely to be much lower. These plans also are likely to have residency or other requirements.
Education savings plans function more like a traditional investment or savings plan. You put money in, choose from your plans investment options and watch the money grow. Plans often have a mix of at least one interest-bearing type of fund, mutual funds, ETF funds, and target-date funds you can choose from. (If that sounds like gibberish, don't worry. Here's a quick explainer.)
You can learn more about the different kinds of plans and their pros and cons here.
Must I — or should I — use my state's 529 plan?
It depends. And unfortunately, there's no quick answer because the best choice depends on the specifics of where you live and what your savings goals are.
Contrary to popular belief, you can open a 529 plan in any state, no matter where you live. If your state offers tax breaks or other benefits for residents who contribute to a plan, that may well be your best choice. However, if your state plan (tax-advantaged or not) offers poor investment choices, high fees, or has other concerns, it's worth looking at other states for better options.
You should also consider your family's unique goals and circumstances. For example, if you have a second residence in another state, plan to move by the time your child starts college, or the student is likely to attend State U like the prior five generations of your family, plans in those states may be a better choice.
It'll take some work, but it's worth it. Using information from credible financial reporting sites that analyze and rank 529 plans, such as Morningstar and CNBC, can help you sift through all the details faster.
Who can use the funds from a 529 plan?
Any distributions from a 529 must be used for educational expenses of the designated beneficiary. In other words, the child the account was set up for. If you need to, you can change the designated beneficiary. So, if you discover your child doesn't want to go to college, or won't need all the funds that are available, you can still use those funds for another child — you just have to transfer the funds or change the beneficiary on the account first. (This is typically a straightforward process.)
Will a 529 plan reduce my financial aid?
Short answer: Yes. Longer answer: Yes, but it's still worth it.
Hear us out: Any assets held by the student or their family are taken into account when you fill out the FAFSA to apply for federal financial aid. But as long as your 529 plan is owned by a parent or guardian and the child is only the beneficiary, it will only reduce your potential financial aid by less than 6%. (This doesn't apply if the 529 is owned by the student, so make sure you set it up right.)
Put another way: For every $10k you have in a 529 plan, your financial aid would be reduced by about $560. But the $10k you have saved will more than cover that relatively tiny deduction. (And remember, you've gotten some tax breaks along the years too, which likely saved you more than the $500-600 you "lost" in financial aid.)
So yes, while a 529 plan can slightly reduce your anticipated finanical aid offer, you still come out ahead because your savings more than make up the difference and can reduce your student's need to take out student loans. (Still need convincing? Here's a great breakdown of how it works in two different scenarios.)