A Guide to 529 Plans and Other College Savings Options

What Are 529 Plans?

529 plans offer a variety of financial aid and tax benefits that make them the most common choice for people interested in saving for college.

In addition to tuition and fees, you can use the money in a 529 plan for textbooks, computers, internet access, and room and board. Plus, thanks to the Tax Cuts and Jobs Act of 2017, you can now receive tax-free distributions of up to $10,000 per year per beneficiary to pay for K-12 tuition.

Nearly all 529 plans are state-sponsored, and most states offer a 529 plan. However, you're not limited to investing only in the plan that belongs to the state in which you reside. Nor must your child attend school in that state.

For example, you can be a Maryland resident who invests in a California-sponsored 529 plan but sends their child to a university in Massachusetts. You can even apply the money in a 529 to tuition at more than 400 colleges and universities abroad.

Not all 529 plans are created equal, and some states offer enticing tax incentives to investors. It pays to shop around and compare different state 529 plans before making a final decision.

What Are the Types of 529 Plans?

There are two types of 529 plans:

College Savings Plans. These work similarly to Roth IRAs. You invest after-tax contributions, and you can withdraw funds later to apply toward qualified expenses.

Although these plans can offer several options when it comes to investments, most of them invest in mutual funds. The value of your plan will fluctuate according to the performance of the investments held within its portfolio. These are the most common types of 529 plans, but they're not guaranteed by the state or federally insured.

Prepaid Tuition Plans. These 529 plans let you pre-purchase college credits or units and room and board at current prices to be used in the future. In essence, you're betting that college tuition will increase in the future. These plans are guaranteed by the state.

Although prepaid tuition plans are meant to be used for in-state public colleges, you can convert them to apply to tuition at private and out-of-state universities too. There's also a prepaid tuition plan that's offered by a group of private colleges.

The Benefits of 529 Plans

529 plans may not be perfect for every situation, but it’s easy to see why they’re the most common strategy for college savings. They’re generally a cost-effective way to store money for college, and they often lead to the highest possible return on investment.

Federal Taxes

The money you contribute to a 529 grows tax-free, and you can take the money out without paying taxes as long as you use it for educational expenses.

Since your contributions grow tax-free, you’ll keep a significantly higher portion of your returns relative to other investment accounts.

Taxes can take a substantial chunk out of your savings and make it much more difficult to reach your college savings goals. For example, conventional capital gains, are subject to a tax of 15 percent whenever they’re sold.

In contrast, the money you withdraw from a 529 account isn’t taxed at all. Taxes might not sound like much, but they add up to a lot when you’re investing over a long period of time.

State Taxes

In addition to these federal tax benefits, many states offer their own incentives for 529 plans that allow you to keep even more of the money you earn.

Many people don’t consider state taxes when comparing different investment options, so don’t forget to take these benefits into account if you’re considering a 529 or another college savings plan.

Flexibility

Everyone expects their 529 plan to go to the intended beneficiary, but the truth is that college is completely unpredictable. 529 plans can be transferred to another family member without incurring a penalty, so you don’t have to use it for the original purpose.

For example, if your first-born child doesn’t go to college, you can simply hold the account until the next one leaves high school Alternatively, you can continue to save before using the funds in your account to cover tuition costs for a nephew, niece, or grandchild.

Alternatively, you can name yourself as the beneficiary of a 529 plan in case you decide to go back to school later in life.

You can also withdraw your earnings from a 529, but you'll have to pay income tax and a 10 percent penalty. However, the penalty will be waived if the child receives a tax-free scholarship, becomes disabled and can no longer attend college, passes away, or attends a military academy.

Keep in mind that, even in these cases, you'll still need to pay federal and perhaps state income tax on your earning.

Why Not Use a 529 Plan?

While 529 plans are the most popular way to save for college, they aren’t necessarily the best choice in every situation. It’s critical to consider your unique circumstances before committing to any college savings method.

Penalties

If you don’t end up using the money for education, for example, you’ll have to pay taxes on distributions along with a penalty fee of 10 percent. This makes 529s less flexible than many other choices for both saving and investing.

Although the federal government now allows 529 plans to be used for educational expenses before college, it’s unclear whether all states will provide the same options. Some states may charge their own penalties on these withdrawals, and you could even be held responsible for previous deductions.

Gift Tax

Keep in mind that if you contribute more than $15,000 into a 529 plan in 2019 you’ll need to file a gift tax return. Luckily, you won’t actually be responsible for paying federal taxes on this amount unless your taxable estate exceeds $11.4 million ($22.8 million for married couples).  Note that this estate tax lifetime exemption amounts are set by Congress periodically so will likely be different when you (and your spouse, if married) pass.

If your spouse also contributes to the 529, combined, the both of you can contribute up to $30,000 without having to report the gift to the IRS.

529 Alternatives

These are a few of the most common alternatives to 529 plans for people interested in a more flexible option for college savings.

Savings Accounts

Savings accounts don’t offer the same potential for growth as investment accounts, but they come with significantly more liquidity along with additional flexibility when you withdraw the money. If your child doesn’t want to go to college, you won’t need to change your financial plans just to accommodate their change of heart.

On the other hand, this easy access to your funds can make it more difficult to avoid the temptation to use the money before your child goes to college. It’s much easier to take money out of savings in a pinch than to withdraw from your child’s 529 plan.

While savings accounts typically offer relatively low interest rates, some high-yield accounts provide interest up to around 2 percent. This isn’t as much as the average investment account, but it’s still significantly more than traditional savings accounts that usually offer only a fraction of a percent.

Roth IRAs

Roth IRAs are another great way to save for your children’s future education expenses. That’s because they’re much more flexible than 529 plans when it comes to withdrawing funds.

Although Roth IRAs are meant for retirement savings, you can withdraw from the funds that you’ve contributed (not the earnings) without penalty for any reason once you’ve held the account for five years.

However, Roth IRAs also let you withdraw money from your account earnings to pay for qualified college costs without paying the usual penalty (10%). However, you will owe taxes on the earnings you withdraw (unless you’re over 59½, of course).

Brokerage Accounts

Conventional investment accounts don’t come with the same tax benefits as 529 plans and other tax-advantaged accounts, but they still give you the opportunity to earn substantial returns and grow your savings over time. The difference between an annual return of 2 percent and 5 percent, for example, could lead to hundreds or even thousands more dollars over the life of the account.

The main disadvantage of brokerage accounts is that you’ll be subject to taxes on capital gains whenever your investments grow. Some brokerages charge their own fees and commissions on top of these taxes, potentially cutting into your funds.

Like savings accounts, brokerage accounts allow you to withdraw money at any time and for any purpose. That said, they’re prone to fluctuations and come with substantially more risk than a savings account with a set yield. Whether a brokerage or savings account is right for you depends on your financial situation and your comfort level with the risks of investing.

Coverdell Education Savings Accounts

Similar to 529 plans, Coverdell Education Savings Accounts are designed to help families save for educational expenses. You can use contributions for tuition, room and board, or other college costs along with tuition at a private elementary, middle, or high school.

Coverdell Education Savings Accounts are limited to those with a gross income of no more than $110,000 per year, or $220,000 if you file jointly. You’ll need to look for another savings option if you earn more than the limit or plan to contribute more than $2,000 per year.

Custodial Accounts

Custodial accounts are savings or brokerage accounts that are managed by an adult for the benefit of someone under the age of 18. The child takes control of the account once they turn 18 and can then use the money however they see fit.

While Coverdell Education Saving Accounts are technically custodial accounts, there are two other kinds of custodial accounts: those created under the Uniform Gift to Minors Act (UGMA) and those that came about with the Uniform Transfer to Minors Act (UTMA). You can create an UGMA account in any state and an UTMA account anywhere except South Carolina.

There’s no limit on contributions to custodial accounts, but you will have to file a gift tax return if you contribute more than $15,000 in 2019 (remember, that number doubles to $30,000 if you get your spouse involved). Investment returns are tax-free for the first $1,050, while the next $1,050 are taxed based on the child’s income tax rate. After that, they’re taxed as regular capital gains.

The Bottom Line

529 plans are a great choice for college savings, but they’re far from the only option. These are just a few of the most effective ways to add to your child’s college fund. Start making contributions as soon as possible to get one step closer to your savings goal.

Logan is a CPA, personal finance expert, and founder of the finance blog Money Done Right, which he launched in July 2017. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money.