How Do 529 College Savings Plans Work?

Written by: Kristyn Pilgrim
Updated: 6/02/20

Investing in college can be intimidating for prospective students and their families. Tuition costs have been rising, with no sign of slowing down momentum any time soon. As first reported by CNBC, the average tuition and fee rates for private four-year institutions have skyrocketed a whopping 26% over the last decade, and public four-year institutions a staggering 35%. For most people, this can be a very intimidating financial burden to bear the brunt of, and understandably so.

Fortunately, it’s not a burden that students nor their loved ones will need to shoulder all at once; with the aid of a 529 college savings account, you can brace for impact and lighten that load well in advance. These plans are offered in all 50 states, tax-free, eligible for institutions in all 50 states, and can be opened by all Americans who are legal adults, regardless of income level. If you’re looking for effective methods to save for your or your children’s higher education, considering 529 college savings plans as an option is a must. Whether you’re a prospective student or the parent or guardian of one, here’s what you should know about 529 college savings plans.

What Is a 529 College Savings Plan?

Ostensibly, all 529 plans, or “qualified tuition plans,” are designed to encourage saving for future higher education costs. Legally, they are sponsored by both public state government agencies and private education institutions, named after Section 529 of the Internal Revenue Code, which covers a lot of regulations surrounding such tuition plans; for more on that, head on over to the Legal Information Institute of Cornell Law School. In general, these plans allow you to set current earnings aside for future use to fund higher education efforts. These earnings are not affected by tax deduction, so long as they’re put toward “qualified education expenses,” a term which often goes beyond tuition to encompass room and board, books, study equipment, and other supplies that you’ll likely need for college.

However, 529 plans that are spent on nonqualified expenses may be subject to taxable penalties, and all 529 plans may be subject to the caveat of their own enrollment or application fees, maintenance fees, and management fees. However, all of these tax benefits and fees may vary by state and provider, as well as the application process itself, so you’ll want to use a reference, like this PolicyGenius guide, to evaluate them accordingly. These aforementioned penalties may also be deducted if the beneficiary dies, becomes disabled, or receives education assistance from other sources.

It can be nice to have the simplicity of saving in advance and being able to stay ahead of the curve of inflation. Though advantageous in some ways, these plans are not without their flaws in other ways, including the aforementioned fees and penalties, the potential to affect qualification for need-based aid, and an IRS-mandated limit of only two asset reallocations a year, an Obama-administration era expansion reported by the Wall Street Journal. However, there are two types of 529 saving plans available, each with their own unique merits and disadvantages depending on your situation. Read on for a full overview of prepaid tuition plans and education savings plans.

What Is a 529 Prepaid Tuition Plan?

A prepaid tuition plan is pretty self-explanatory; it enables you and/or the beneficiary to pay for credits at participating institutions, at their current tuition and mandatory fee rates, without being concerned with inflation and price hikes. Most prepaid tuition college savings plans are sponsored by state governments, run through public institutions, and largely prioritize in-state residency above all else. If you or your children would rather opt for private schooling, you can look into the 529 Private College Program for a 529 prepaid tuition plan. Prepaid tuition plans offer the simple, straightforward luxury of conveniently paying ahead in advance, and paying ahead of any increases that inflation may bring. 

Prepaid tuition plans are not exempt from those aforementioned flaws, as well as state regulations that may not work to your advantage. For instance, if the provider’s state government sponsor encounters sudden funding cuts, it may maladaptively affect the bottom line of your own savings placed into the plan. Additionally, a fee that may be affordably low in one state might be exorbitantly high in another. Before you evaluate any one plan, always read up on your state’s regulations and costs, evaluate them comparatively with other areas and institutions, and use tools like the Financial Industry Regulatory Authority’s Calculator Tool to do so, or Saving for College’s 529 Comparison program.

What Is a 529 Education Savings Plan?

The other type of 529 college savings plan open to consumers allows the saver to open a funding account for their beneficiary, and maintain full control over the account in question. Not only can these types of 529 plans be applied to university, but for public, private, and religious elementary and secondary schooling, as well, per the U.S. Security and Exchange Commission. This support can be awarded at rates up to $10,000 per beneficiary per year and can be placed toward a wider array of education investments, including mutual funds, bank products, and ETF portfolios.

Like prepaid tuition plans, invested earnings are generally not subject to taxation, so long as they’re used to fund qualified educational expenses. Unlike them, however, applicants do not have to be residents of the state offering them to qualify for opening most 529 education savings plans. An education savings plan may be an advantageous option if you want a little more versatility over your location and your assets, but keep in mind that they can still be subject to many of the same disadvantages that prepaid tuition plans may be subject to. 

Before you commit to any one particular 529 plan, evaluate it carefully and thoroughly with the aforementioned tools, or whatever methods work for you.