This 529 Plan overview article has been updated for the 2022 & 2023 tax years. One of the most requested posts I have received since starting this blog is to cover 529 plans. Why? My take is that many readers of this site are having children for the first time and have bundles of fear around what education costs might be in 15-18 years with the rapid pace of tuition inflation, and no relief in sight.
It’s a valid concern, particularly if you belong in the camp who believes that a 4 or 6-year university degree is a prerequisite for a decent paying job. According to the US Department of Education, inflation on the average annual cost of 4-year public schools often is over 4% per year. In inflation adjusted dollars, 1 year of tuition and fees has increased by $900 in the last decade. The rapid pace of education inflation for such degrees has led to what will undoubtedly be one of the greatest challenges in the country – the student debt crisis.
I do not belong in the camp that feels a 4 or 6-year degree is a necessity to a well paying job (though it certainly can help), and the ROI can work out to an individual’s disadvantage in some cases. Nevertheless, if a formal college education is a priority for your family (doesn’t have to be just your child), this post should help set the framework.
What is a 529 Plan?
A 529 plan, at its simplest, is a tax-advantaged savings plan designed to encourage saving and investment for future education costs for a designated beneficiary. They are also referred to as QTPs (Qualified Tuition Programs), and the “529” moniker comes from the section 529 of the IRS tax code they reside in.
There are two types of 529 plans – prepaid tuition and a savings plan – and the differences between them will be covered in greater detail.
529 savings plans are administered at the state level and all 50 states have one. You are free to choose a 529 from any state, however, there may be advantages to staying within your state of residence, as we’ll discuss.
Anyone can set up a 529 plan, and you can name anyone as the beneficiary – friend or family.
Can you Open a 529 Plan for Yourself?
Yes you can use a 529 plan for yourself. But, don’t view it as a tax-advantaged alternative retirement account. More on that later…
What are the Benefits of a 529 Plan?
Some states allow tax deductions on part or all of contributions. 529 earnings are tax-deferred and distributions are tax-exempt (given that they meet IRS criteria). In this regard, they are kind of like Roth IRAs, with the additional possible benefit of a state income tax deduction.
Before looking out of state, you may want to look within. Many states offer benefits within their plan only to state residents. These can include tax advantages, matching scholarships and grants, protection from creditors, and exemption from state financial aid calculations.
If you are interested in having a beneficiary participate in a post-secondary education in the future, putting away savings now can have a hugely beneficial impact, given the aforementioned rising costs of tuition.
Another major benefit to 529s is who owns the account – which I’ll detail next.
Who “Owns” the 529 Account?
We recently covered custodial IRAs for minors. One of the interesting things about custodial IRAs is that the true owner of the account is the minor. A custodian just manages the account until the minor becomes the age of majority.
529 plans are entirely different, in this regard. Anyone can set up the account and name a benefactor of their choosing. The owner is the individual who establishes the account, and that person has complete control over the plan. This does not change as a minor reaches age of majority.
The beneficiary can also be changed at any time.
Are there Any Disadvantages to a 529?
Contributions to a 529 plan are NOT federal income tax deductible. Any unqualified distributions are subject to income tax (earnings) and an additional 10% penalty (more on this later).
There is also the possibility that 529 funds used for educational expenses may reduce the student’s eligibility for need-based financial aid.
529 Prepaid Tuition Plan Vs. 529 Savings Plan
|Prepaid Tuition 529||529 Savings Plan|
|How it Works:||You pay now for future education. Price of tuition is locked in at today's prices at participating institutions.||Works more like an investment account where you can contribute and withdraw at the time the benefactor has education costs.|
|Expenses it can be Used Towards:||Tuition & mandatory fees. Some plans allow you to pre-purchase room & board or use excess tuition credits for other qualified expenses.||All qualified education expenses, including tuition, room & board, mandatory fees, books, & computers.|
|State Residency Requirement:||Residency is required in most states.||State residency is not required, although there may be additional benefits (e.g. state income tax deduction) by purchasing in state.|
|Performance/Guarantees:||Most are backed by state government.||Results vary based on market performance.|
|Age Limits:||Most have an age limit.||No age limits. Beneficiary can be any age.|
|Availability:||9 states (accepting new applicants)||50 states|
Which States Have Prepaid Tuition 529 Plans in 2023?
All fifty states and the District of Columbia sponsor at least one type of 529 plan. However, most have a savings plan only, and just 9 states still have a prepaid tuition 529 plan in 2023. That number has been dwindling. Most of these states require residency in that state.
The following states offer a guaranteed (state-backed) prepaid tuition plan:
The following states offer a prepaid tuition plan, but the terms are subject to change:
529 Income Limits for Contributions (2022 & 2023)
Interestingly, there are no income limits to 529 plan contributions.
529 Plan Contribution Limits (2022 & 2023)
Technically, contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary. The money you put in a 529 account is considered a gift and, as such, qualifies for the annual $16,000 (2022) or $17,000 (2023) individual, or $32,000 (2023) and $34,000 (2023) married filing jointly gift tax exclusion to any individual. For example, you can contribute up to $17,000 annually in 2023 (or $85,000 if you carry forward for the next 4 years), per beneficiary, without incurring any gift tax. You can contribute more, but you would incur the gift tax. For more on this topic, check out the instructions for IRS form 709.
What Types of Institutions can you Use a 529 for?
Eligible educational institutions generally include colleges, universities, vocational schools, or other post-secondary educational institutions that are eligible to participate in a student aid program administered by the U.S. Department of Education.
529 Qualified Expenses
Funds from a 529 savings plan can be used for:
- mandatory fees
- books & required supplies and equipment
- computer, related equipment, & internet access
- room & board (if at least half-time student)
at any accredited college, university or vocational school in the United States and at some foreign universities.
Funds CANNOT be used towards any sort of student loans or student loan interest.
Prepaid tuition plans have varying rules, but usually cover tuition and mandatory fees only.
Transferring 529 Beneficiaries
Lets say you have a spouse or child that ends up not going to post-secondary school, and you want to change the beneficiary to another family member. This can be done, with no tax consequences.
You can even change yourself to the beneficiary, if your child no longer needs the savings.
And you can roll over funds from one 529 plan to another (e.g. one child’s 529 to another, or a child’s 529 to a spouses), if you’d like.
What if the Funds are Not Used?
This is the big question. What if you contribute thousands, even tens of thousands over the years, only to find out at a later point that the money cannot be used for any beneficiary? What happens to the funds then?
We already covered that you can change beneficiaries.
Beyond that, most plans allow you to reclaim contributed funds for yourself at any time or make yourself the beneficiary. However, as mentioned earlier, any unqualified distributions are subject to income tax on gains and an additional 10% penalty. This does not change over time and 529 plans cannot be converted into IRAs or other retirement plans.
There are exceptions to the tax and 10% rule if the distributions are:
- Paid to a beneficiary or estate of the beneficiary upon death.
- The designated beneficiary becomes disabled. A person is considered disabled if there is proof that he or she cannot do any substantial gainful activity because of a physical or mental condition. A physician must determine that the individual’s condition can be expected to result in death or continue indefinitely.
- Beneficiary receives education assistance for U.S. military service (distribution must not exceed costs of education).
- Included in income only because the qualified education expenses were taken into account in determining the American opportunity or lifetime learning credit.
- The designated beneficiary receives any of the following:
- a tax-free scholarship or fellowship
- veterans’ educational assistance
- employer-provided educational assistance
- any other tax-free payments (other than gifts, bequests or inheritances) received for education expenses
Are 529s the Answer to Soaring Tuition Costs?
If you start a plan at the birth of your child and contribute early and often, 529s can help limit the impact of tuition inflation. However, college education costs can be prohibitively high already – averaging $19,189 per year already for a 4-year public institution. One has to hope this bubble bursts sooner than later, or a post-secondary education will be a thing reserve for the financial elite only.
More Information on 529s
If you are interested in a 529 plan, review all the fine print. Plans differ per state and some state’s plans are inferior to other state’s plans. All plans are not created equal. Also, take a few minutes to review section 8 of IRS publication 970 on qualified tuition programs.
529 Plan Discussion:
- Have you started investing in a 529? Prepaid or Savings? And why?
- Have you invested in a 529 plan from a state other than one you reside in? Which state and why?
- Have you invested in a 529 plan for reasons other than paying for your child’s future education costs?
I live in the UK. We have nothing like a 529 plan but what a great idea. Tuition costs are rising so rapidly and yet at the same time wages are not keep pace. It does concern me in the future about tuition fee costs. That’s why i’m saving now!
Absolutely everything about this whole idea makes me feel icky and squirmy and hopeful that Tom Morello will be elected president. They (I’m being sort of nonspecific with this ‘they’ but I’m kind of picturing a bunch of private equity folks, a few lobbyists, and a few of their buddies in congress) have convinced us for years that we have to spend much more than our parents ever earned to get an education. So an entire generation is now in debt, and now they are telling us that we need to start saving for our kid’s college (kid singular, noone can afford college for more than that – see for example http://www.theatlantic.com/sexes/archive/2013/02/dont-rule-out-having-children-because-you-want-to-have-a-career/273154/ ) because if we don’t start dumping our money into some fund that Wall Street can play puff-puff give with for the next 20 years, we’re going to end up with our kid paying $400K out of our pocket and we won’t be able to retire until we’re 68.
The assumption that tuition will go up exponentially forever is about as founded as the fact that housing prices were to continue their trend in 2005. At some point, real economics gets in the way, and people start asking what on earth are we doing here, shoveling away hundreds of thousands of dollars for skills many of which could be learned online or better yet, on the job. Obviously the system is going to start to have some cracks. Of course, the elite people who have a couple hundred thousand to drop into their account for when little Jaspy goes to Princeton will continue to live the life like they’re Downton Abbey, but the rest of us are going to think better of it.
Of course, there will all be suckers, who are scared by the anxiety of not affording future college for their kid.
Another huge problem is that people have stopped having kids because this is the kind of discussion that comes up – you aren’t fit to be a parent unless you’ve set up an account like this – and as a result the middle class birth rate is plummeting. We are all going to retire when we are 80, because in thirty years, the middle class will have been completely hollowed out – we better hope that India and South American keep sending people here because our economy isn’t going to support a population with is 2/3 retired.
Very informative post. I think with the rising tuition cost this will become more of a necessity if parents want to send their kids to college. The fact you can make yourself the beneficiary if your kid doesn’t go to college makes this a very attractive option.
Im 22 and in the military. I have one year left and will be going to school full time after that. I have a 529 plan in my name with about 9k. I believe it was started with 8k.
I realize I can claim the money since I will have basically a full ride through the GI Bill. But you stated “distribution must not exceed costs of education”. What does that exactly mean? For the year? Semester? Obviously my education in the long run will be much more than 9k. Just curious. 9k Would go very nice with my current portfolio.
Good post. I just opened a 529 for my one-year old, and did a lot of research before I decided on a plan. I thought I would highlight a few additional points:
1) Most states offer their own 529 (and a few lucky states will even offer matching dollars for 529 savers if you are a resident in that state), but financial firms like Vanguard and others also offer 529 accounts, so you can look broader than just the state’s offerings. The financial firm’s 529 plans don’t come with the state tax-deduction incentive, but they can have very low cost ratios (see my point #3 below).
2) Most states offer two different types of 529s – an “investment” option, where the 529 is managed as an investment, or a “savings” option, where the money in the 529 is placed into bonds/CDs. Also, some investment plans will automatically “adjust” as your child ages, moving more funds into bonds/CDs as your kid gets closer to college-age. However, they don’t all do this, so it’s helpful to think through how hands-on or hands-off you prefer to be with the 529, and then look for a good match.
3) If you are leaning toward a state plan because your state allows a tax deduction for any 529 contributions, it is VERY important to look at the 529 management expenses. I live in Montana, which does have a state plan that offers state tax deduction for 529 contributions (up to $3,000 per person), but the cost ratio of administering the plan is outrageous (between .89%-1.29%; Vanguard, for comparison sake, is .29%). I did the math, and even with the state tax deduction, I would end up saving much more over the long run (assuming the same rate of return) by going with a lower cost ratio fund. Be sure to pay attention to that.
4) There are several existing programs that help you augment your 529 contributions. For example, Upromise (and there are others, but I’m forgetting them off the top of my head) is a program that has deals with a number of national chain stores. If you are ordering something online, if you access that store’s website through the Upromise website, they will send 5% of the cost of your purchase into your beneficiaries account that you can then send to your 529. You can also register your credit cards with them and again, when you purchase something from a partner retailer, a portion of the cost of the purchase will be deposited in your beneficiaries account. Some people add a few hundred bucks a year that way, although my buying habits don’t seem to be as beneficial as all that.
Great additions, thanks!
Great summary. Regarding the transfer of ownership to another family member, do note that just because there aren’t ‘income tax’ consequences of transferring the beneficiary to another family member, there may still be potential gift taxes owed since you are in essence gifting from one person to the next. However, for most people, this likely wouldn’t be an issue particularly if you elect the 5 year gift option at that time. This is an area that the IRS is vague about especially since 529 plans really haven’t been around all that long.
Naturally, CA is one of those states NOT on the list for prepaid tuition plans.
What about an ESA (educational savings account)? I don’t know much about them but I plan on doing some research since I probably will be having a child soon and want to start saving for college as soon as we can. Are ESA’s a good option?
They are inferior to 529’s in just about every way.
Very interesting article. I think the real solution to rising tuition costs is something that will never happen: people need to stop being willing to pay so much.
Locking down your child’s school choices to the state you happen to currently live seems too risky. I decided to go Roth IRA so I can save for my retirement and use the contributions for tuition.
I haven’t gotten too far so please let me know if I’m crazy.
529 savings plans may have additional tax benefits for that state, but they are not locked down to only in-state schools. Prepaid might be a different story, depending on the plan.
Thanks for the reply that’s good to know.
I have a few reasons for doing a Roth. I’ve upped my 401k contribution to 10% and upped my weekly HSA contributions as to max out for this year (2012 I paid less than 10% in taxes). I would like to balance the tax deferred with tax exempt and not dilute the concentration of savings.
Then, if my daughter does go to college I could pay for tuition with Roth contributions while have gotten 13 years of compounded growth.
Inflation is about to get much worse, once all this ‘cheap money’ hits the market from QE1, QE2, QEinfinity…
This article does a good job covering the basics. It is ALMOST ALWAYS better to invest in a 529 plan over investing after tax, even if you never intend to spend the money on qualified education expenses. The 10% non-qualified withdrawal penalty is more than offset by the benefit of the dividend gains are compounded tax-free over the.
I am 27 years old, not yet married, but I have contributed the maximum $5000 tax deductible amount every year.
If you want to double check my math, I’ve included my assumptions below.
After Tax 529 plan
Year Account non-qualified withdrawal
0 $100.00 $100.00
1 $106.60 $107.00
2 $112.36 $114.49
3 $118.42 $122.50
4 $124.82 $131.08
5 $131.56 $140.26
6 $138.66 $150.07
7 $146.15 $160.58
8 $154.04 $171.82
9 $162.36 $183.85
10 $171.13 $196.72
11 $180.37 $210.49
12 $190.11 $225.22
13 $200.38 $240.98
14 $211.20 $257.85
15 $222.60 $275.90
16 $234.62 $295.22
17 $247.29 $315.88
18 $260.64 $337.99
19 $274.72 $361.65
20 $289.55 $386.97
Cost basis $132.00 $100.00
Capital gains $157.55 $286.97
tax $31.51 $57.39
non-qual penalty $28.70
Net 258.042796 300.8779124
20% dividend/capital gains tax rate
10% non-qual pentalty on earnings
no upfront tax deduction (e.g. CT and NY offer a deduction)
investing options are the same (in reality, 529 investment options are more limited)
Oops, I accidentally hit reply before completing.
In summary, the 529 plan is amazing.
If you spend it on education expenses, it’s a huge tax benefit
If your state gives you a tax deduction for contribution, it’s a medium tax benefit.
If you don’t spend it on education expenses, there is no financial downside. In fact, you come out a little better than with a regular after tax account.
Don’t focus too much on the calculations. I’m just showing that there is no financial downside to making a non-qualified distribution vs investing in a normal after tax account.