What is a 529 plan? How does it work?

A 529 plan is a tax-advantaged savings plan in the United States designed to help individuals and families save for education expenses.

One of the main advantages of 529 plans is the potential for tax benefits. The earnings grow tax-free and withdrawals are not subject to federal income tax if they are for education purposes. If not then they have a 10 percent penalty.

There are two types of 529 plans: college savings plans and prepaid tuition plans. The former is for a beneficiary’s education expenses, while the latter allows you to prepay future tuition costs at today’s rate.

How does the different 529 plans work?

For both plans, the account holder can make contributions, though as this is done through after-tax dollars they are not deductible on federal income tax returns. While there is no monthly limit, most states have an upper overall limit which can be into the hundreds of thousands of dollars.

College savings plan funds can be withdrawn tax-free when used for qualified education expenses. This includes expenses such as tuition, fees, books, supplies, and, in some cases, room and board. There is a $10,000 limit on using this money for K-12 students.

Prepaid Tuition Plans are a bit different and much rarer, only available in nine states.Contributions are made based on a contract for an in-state institution.

This plan cannot be used for other education expenses unlike the college savings plan. While they are useful in times of high inflation, like the last 18 months, they may not be necessary when inflation is at the Federal Reserve’s 2 percent target; the money would be better used in the college savings plan.

Furthermore, being restricted to one state may not be in your child’s plans. If they choose not to stay in-state then the money is returned.