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As you may already know, college can be quite costly. If you’re planning for your child to attend a university or vocational school, it's wise to start saving as early as possible. One of the best ways to do this is by investing in a 529 college savings plan, an education-focused investment option.
Understanding How a 529 Plan Functions
529 savings plans, named after the IRS code, are intended for educational expenses, including tuition at elementary, secondary, vocational, or higher education institutions (both domestic and eligible international schools). Similar to other long-term investment accounts, you deposit funds and let them grow through compound interest until you're ready to withdraw. To invest in a 529 plan, you must be at least 18 years old.
The primary advantage of a 529 plan is that while your contributions are taxed initially, the earnings grow tax-deferred over time, much like a Roth IRA. A major benefit is that withdrawals made for qualified educational expenses (such as tuition, laptops for school, or student housing) are not subject to federal tax, and often, they are exempt from state tax as well. You can check your state's deduction policy here. In some cases, you could potentially save about 30% of your withdrawal amount in taxes, depending on your state's rules.
Unlike other investment accounts, 529 plans are state-sponsored, meaning the options available can differ depending on the state where you open your account. Some states offer a variety of plans, which you can find by state here. (If you'd rather not deal with this, you can hire a financial advisor to help you select a plan, for a fee).
There are two main types of plans
There are two broad categories of 529 plans: prepaid plans and investment plans (although some states don't offer both).
With a prepaid plan, you pay in advance for a year of tuition or course units, locking in the current rate. Essentially, you’re paying now to avoid future cost increases. The downside is that these plans may be limited to in-state schools only.
With an investment plan, you have the flexibility to decide how to allocate the money you save. Although the funds must still be used for educational purposes, you aren’t tied to fixed tuition rates or college units like you would be with a prepaid plan. This flexibility is why most experts recommend opting for an investment plan.
Most 529 investment plans offer both age-based and custom options. With a custom plan, you have full control over how to manage and adjust your portfolio. On the other hand, an age-based plan automatically adjusts the portfolio mix as the beneficiary approaches college age. These plans typically start with a higher percentage in stocks (e.g., 80-100%) and gradually reduce stock exposure (e.g., 10-20%) to minimize risk as the withdrawal time nears. The goal is to maximize growth early on and lower the risk later.
How to set up a 529 plan
Before opening your 529 plan, choose the state you want to go with. The state that sponsors the plan doesn’t require the school to be in-state (although prepaid plans might have this restriction), so you can use the funds for any eligible school, even out of state.
Use this tool to compare plans across different states, including fees and investment options. Vanguard also provides a state tax calculator to help you determine the potential tax benefits you can receive.
Make sure to read the program disclosure statement before selecting your plan so that you’re fully aware of the terms and rules. In short, always review the fine print.
When enrolling, you'll need to designate an account owner (likely yourself). Most 529 plans do not allow joint ownership, but family members and friends can contribute to a 529 account.
You'll also need to name a beneficiary—the person who will use the funds for college (most likely your child). Remember, the account owner controls the assets, not the beneficiary. You can generally link your checking or savings account to your 529 account for automatic contributions.
Important guidelines to keep in mind
Unlike other types of tax-advantaged accounts, 529 plans don't have a fixed contribution limit as set by the IRS. However, most states set their own contribution limits, typically ranging from $350,000 to $500,000, according to Nerdwallet.
A key consideration is the gift tax implications: The IRS notes that if your annual contributions to a 529 plan, in combination with other gifts, surpass $15,000, you may be subject to gift tax. There is, however, a workaround through a strategy called superfunding.
Additionally, it’s easy to alter the beneficiary of your 529 plan. For instance, if your child receives a scholarship and no longer needs the funds you’ve invested, you can transfer the beneficiary status to a sibling with little hassle.
While a 529 plan is a fantastic way to address rising education costs, make sure to use the funds for qualified educational expenses. Otherwise, your withdrawals could be subject to income tax, plus an additional 10% penalty.
