What is a 529 education savings plan?

For many families, saving for education feels like a luxury expense that can be put off for another month or two or more. However, when it comes to long-term financial goals, time is money. If you start saving early enough, even minor contributions of $20 or $30 can add up over the years. And if you use a 529 account, the money you contribute can grow even more.

What is a 529 plan?

A 529 plan is a tax-advantaged account designated for education expenses. Named for its section of the IRS code, a 529 plan was originally designed to pay for college only, but in 2017, it was expanded to include K-12 tuition. And in 2019, it was expanded again to include the costs of an apprenticeship.

There are two types of 529 plans:

• Savings plans: A 529 savings plan grows without incurring a federal tax liability, and earnings remain tax-free if they are used for qualified education expenses.
• Prepaid tuition plans: With a 529 prepaid tuition plan, the account owner can lock in today's tuition rates by paying in advance for tuition at a designated college or university.

How does a 529 plan work? 

The reason to open a 529 plan is to save for future educational expenses for your child or grandchild, or someone else, in a tax-advantaged way. Anyone can open a 529 account, but usually, parents or grandparents open the account to save for a child's future education.

Each 529 account can have only one beneficiary at a time. If you have multiple children, you can only name one of them as the beneficiary on a 529 account and can only use the funds to pay for that child's education. However, you (as the account owner) can change the beneficiary at your discretion. It's recommended to have a separate 529 account for each child, especially if they'll be in school at the same time. But you could technically have one account and just change the beneficiary when one child finishes school, and you're ready to use the account for the next child.

You can save and invest in other types of accounts for educational expenses, but those earnings would most likely be taxed. A 529 account offers unique tax advantages for educational savings.

What are the tax benefits of a 529 plan?

You will never have to pay federal taxes on the earnings in a 529 account, as long as you use the funds for qualified educational expenses. For example, according to SavingForCollege.com's calculator, if you start saving $20 each week in a regular savings account when your child is eight years old, you would end up with $10,700 when the child reaches age 18. With a 529 plan, you would end up with about $16,000. Not only would you end up with more money for education with the 529, but you won't need to pay taxes on that extra $5,300, if it's used for qualified education expenses. And if you started saving at age two instead of eight, the total in the average 529 account would reach $31,000.

If you make withdrawals for other uses, you'll have to pay taxes on the earnings at your regular income tax rate, along with a 10 percent penalty. (There are exceptions for some circumstances, such as death or disability.)

The contributions you make to a 529 account are not tax-deductible at the federal level, but many states offer tax deductions or credits for contributions to a 529 plan. In most cases, to get the state tax deduction or credit, you'll need to invest in your home state's 529 plan. For example, Pennsylvania 529 account owners can deduct contributions up to $15,000 per beneficiary (married couples can deduct up to $30,000 per beneficiary) per year from their taxable income.

Who can contribute to a 529 plan, and how much?

Anyone can contribute to a 529 plan. That can include parents, grandparents, aunts, uncles, cousins, and friends.

Each state makes the rules for its own 529 plan, so there are no across-the-board contribution limits. Most states allow a total contribution limit of at least $235,000 per 529 beneficiary. Once the account reaches the state's total limit, it will accept no more contributions.

You also have options to split up your contributions over several years to ensure you maximize your tax advantages. You should consult your tax professional for more information.

What can 529 funds be used for?

Qualified education expenses include all tuition and required fees at the college level and up to $10,000 per year at the K-12 level. But tuition and fees aren't the only expenses for which you can use 529 funds. At the college level, 529 funds can also be used for room and board, books and supplies, computers and internet access, and special needs equipment.

Transportation and travel costs, health insurance, college application and testing fees, and extracurricular activity fees are not qualified education expenses for 529 funds. Students or graduates who have student loans can use a maximum of $10,000 from a 529 plan to repay student loans.

What if my child doesn't use the 529 funds?

If you contribute to a 529 plan and end up not needing the funds for your child's K-12 tuition, college tuition or apprenticeship program, you do have other options. First, you can change the beneficiary on the account to another eligible family member, including the siblings, cousins, parents, aunts, uncles, spouse, or children.

In some cases, the original beneficiary may develop a disability that prohibits him or her from pursuing further education. In that case, you may be able to withdraw from the account without paying a penalty, or you can roll the money over from a 529 account into a state-sponsored ABLE account (Achieving a Better Life Experience).

Many families hope their children will complete some education program after high school, whether it's college or a vocational program. And saving in advance for that option, while experiencing tax benefits, will likely make it more feasible for children to pursue better career options when the time comes. Starting a 529 plan for your child is an ideal way to help them realize their full potential.