How 529 Plans Work

 

A 529 plan is a way for people to save money for a specific individual to attend an institution of higher education. These plans (and there are many) allow for a tax deferment on all earnings and distributions, provided the distributions are used to pay for qualified expenses.

 

Financial planners consider 529 plans to be the best way for most to accumulate funds for college expenses.

 

A 529 plan is similar to an education savings account, but the maximum allowable contributions for a 529 plan are much higher.

 

There are 2 types of 529 plans:

 

  1. Prepaid tuition programs allow the purchase of credits at a specific school locking in today’s prices. If you know the individual wants to attend a specific college, there may be a state-sponsored plan that will allow you to lock in and pay the current tuition rate.
  2. The more conventional college savings plan allows contributions to make for a specific student. These plans can be started at any time, even the day of the birth of the future college attendee.

The more conventional plan offers much greater flexibility since the monies can be applied to any qualifying school. But if the future college student is positive about their target school, the pre-paid tuition program is usually a better deal.

 

Not everyone is eligible for a 529 plan, but the great majority qualifies. The eligibility rules are very relaxed.

 

Consider these limitations:

 

  1. Essentially, anyone can contribute to a 529 plan for someone else. You can even start one for yourself. The plans themselves can have certain eligibility requirements, like state residence, for instance.
  2. There are no income restrictions. Although there are no income restrictions, there can be age restrictions on the beneficiaries with some plans. The investment options can also be limited in some cases depending on the age of the beneficiary.
  3. The beneficiary can be changed to a qualifying family member. There is a long list of eligible family members who can become the beneficiary.

 

  • For example, if a grandparent sets up a 529 plan for each of their grandchildren and one decides not to go to college, they can change the beneficiary to another grandchild or perhaps a niece or nephew.

 

Anyone that assumes they cannot contribute to a plan or be a beneficiary is probably mistaken. Check it out before you dismiss the possibility of taking advantage of these great plans.

 

These basic rules apply to contributions:

  1. The contribution limits vary from state to state. Limits are usually lifetime limits and are on the order of $200,000, but they can vary. While there is no annual limit, anything above $13,000 will incur a gift tax.
  2. In some states, contributions are tax-deductible. This will vary with the state and the plan. Check out the rules and regulations for your particular state.
  3. In most cases, the investment options are limited to mutual funds and annuities. The options can be based upon the age of the beneficiary. More aggressive options are available for younger beneficiaries.


Distributions are not taxed for qualified educational expenses. Qualified expenses include tuition, fees, books, supplies, tutoring, uniforms, room, board, and even transportation. Special needs are also covered.

 

Any funds not used for educational purposes belong to the person who made the contributions to the plan. These funds can be retrieved, but taxes must be paid on the earnings and a 10% penalty is also incurred. All of the money in the 529 plan always belongs to the donor and can be retrieved at any time.

Right now, 529 plans are the best vehicle to accumulate money for higher education expenses. The eligibility and contribution rules are generous and practically all educational expenses qualify for tax-free distributions.

 

There are many plans with varying rules and eligibility requirements. It’s a good idea to educate yourself about the details of your state and select the best plan for your particular situation.