How a 529 Plan Works for College Savings

how a 529 plan works

Knowing how a 529 plan works will make a big difference when it comes time to pay for college.

You may think this is something you can put off until later, but it’s not.

Like other types of high-yield savings accounts, the sooner you start using it, the more money the 529 plan may have when it comes time to withdraw it.

Plus, college costs continue to rise. When your child attends college, you should anticipate spending significantly more than what you paid to go to college.

Consider these statistics from U.S. News representing the rise in college costs over 20 years:

  • The average tuition and fees at private National Universities have jumped 144%.
  • Out-of-state tuition and fees at public National Universities have risen 171%.
  • In-state tuition and fees at public National Universities have grown the most, increasing 211%.
  • The total consumer price index inflation increased by around 54% from July 2001 to July 2021.

Shocked? You’re not the only one.

According to a 2021 CNBC report, “Students and their parents still underestimate the true cost. […] Roughly a quarter of parents of high school students — and 38% of students themselves — believe the sticker price for one year of college will be $5,000 or less, far below the College Board’s estimate.”

So how much will it cost to send your child to college?

Well, it depends on a variety of factors.

According to College Data, “For the 2020-2021 academic year, the average price of tuition and fees came to: $37,650 at private colleges, $10,560 at public colleges (in-state residents), and $27,020 at public colleges (out-of-state residents).”

Considering inflation, it is wise to expect these figures to be higher when your little one reaches college age.

Hence the reason many parents open a 529 plan to save for college.

Education Data found, “Americans on average want to save $57,981 for their child’s college expenses” and “30% of saving accounts are 529 plans – the largest majority.”

Read on to see how a 529 plan works and if it is the right savings choice for you and your family.

What Is a 529 Plan?

A 529 plan is a tax-advantaged saving plan that may be used to pay for qualified education expenses for a designated beneficiary (or the child the 529 plan is set up for).

When 529 plans first became available, they were solely for college expenses.

However, beginning in 2017, 529 plans were expanded to include K-12 education (such as private school tuition) and apprenticeship programs.

With a 529 plan, the savings grow tax-deferred.

Another bonus of 529 plans is that withdrawals are tax-free as long as they are withdrawn for qualified education expenses.

Qualified education expenses include:

  • Tuition and fees (up to the full amount for college; a $10,000 limit per year for K-12 grade).
  • Books and supplies.
  • Computers and internet access.
  • Room and board (as long as the student is enrolled at least halftime).
  • Student loans (lifetime limit of $10,000).

How a 529 plan works looks similar to a Roth 401(k) or IRA investment savings plan, where the money grows tax-deferred.

According to Education Data, there are 14.83 million 529 accounts in the nation.

Those 14.83 million accounts amount to $425.2 billion.

On average, Americans have saved $28,679 in their 529 accounts.

In fact, 529 plans are the most popular college savings choice for parents.

How a 592 Plan Works

The title comes from Section 529 of the IRS tax code. This section was added in 1996 for tax-advantaged college savings plans for families.

Fortunately, how a 529 plan works isn’t as complicated as it sounds.

It is actually simple to get started, contribute to the 529 plan, and withdraw from it.

Opening a 529 plan follows these basic steps:

#1 Choose the right 529 plan for your family. Start by looking at your state’s 529 plans first. However, you are not tied to your state’s 529 plan. You can invest in any state’s 529 plan, so choose the one that offers the most bang for your buck.

#2 Choose a beneficiary. This is the individual who will receive the money for educational purposes.

#3 Open the account. This will require you to complete the 529 plan application, which requires personal information such as Social Security numbers.

#4 Fund the account. Once the account is opened, anyone can contribute to the 529 savings plan.

When it comes to funding the account, there are several ways to contribute to a 529 plan.

For example, all 529 plans allow for automatic contributions from your bank, including how much and how often.

These automatic contributions make it easy to save for your child’s college without even thinking about it.

While automatic contributions are a good idea, they are not required. You can contribute to a 529 plan at any time once the minimum contribution is met.

In addition, people can contribute lump sums to 529 plans, and there is even an option for family and friends to give 529 gift contributions for birthdays, holidays, and graduations.

How a 529 plan works when it comes to withdrawing is also simple.

You can withdraw from a 529 at any time for any purpose.

However, if it is not for qualified educational purposes, you will pay a 10% tax penalty in addition to regular income taxes.

529 Plan Contribution Limits

When you open a 529 plan, there is usually a minimum contribution required, but this minimum contribution tends to be low ($10 or $15).

After the account is opened, you are not required to continue contributing though many parents sign up for automatic payroll deductions.

In addition, there are no limits on how much you can contribute to a 529 plan annually.

However, if you make contributions above $15,000 annually, you will incur gift taxes or use up some of your lifetime gift tax exclusion.

While there is not an annual limit, states have different cumulative contribution limits, ranging from $235,000 to $529,000.

According to Saving for College, “After a 529 plan account reaches this [cumulative contribution limit] balance, it can still earn interest and appreciate in value, but no additional contributions will be accepted. Most people do not reach this limit.”

592 Plan Withdrawal Rules

As long as you are using the money in the 529 plan to cover the qualified educational expenses for the beneficiary, then withdrawing the money should be easy.

You’ll need to calculate your qualified educational expenses (college expenses, including tuition, fees, books, supplies and equipment, computers, and room and board if the student is enrolled at least halftime OR K-12 tuition and fees of up to $10,000 per year).

Once the costs are calculated, the account owner will submit a withdrawal request.

Most 529 plans allow account owners to distribute money directly to the school.

Any costs that go beyond qualified educational expenses that are withdrawn will need to be reported on the year’s income tax return and are subject to income tax and a 10% penalty.

What Happens If 529 Money Is Not Needed?

As much as we’d like to have a crystal ball to see into the future, we don’t know exactly what the future holds.

There is a possibility your child will choose not to attend college or will earn a substantial amount of money in scholarships.

In both circumstances, the money in the 529 savings plan will not be necessary for educational expenses.

What happens to the money in events such as these?

One option is to change who receives the money.

529 plans allow account owners to change beneficiaries. For example, you can change the beneficiary to a sibling or another family member.

If this isn’t an option and you simply need or want the money, you can withdraw it and pay the penalty.

There is a scholarship exemption, too. If your child receives a scholarship, you will still have to pay income taxes on the earnings, but you won’t be penalized for the additional 10%.

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