How Does a 529 Plan Work? Your Comprehensive Guide

Starting in the 1980s, some states began sponsoring tax-advantaged savings plans to help families prepare for the costs of higher education. As college costs continue to rise, 529 plans – also known as a Qualified Tuition Program – have spread in popularity and now play a vital role in many families’ education funding plan. 529 savings plans are tax-advantaged programs used to save for qualified higher education expenses or certain K-12 tuition expenses.

Types of 529 Plans

There are two types of 529 plans, although both are not available in all states. Check your state’s 529 options to see what is available for you. Prepaid tuition plans are limited in scope and geographic area, while education savings plans are available in all 50 states and the District of Columbia.

Prepaid Tuition Plans

Prepaid tuition plans allow an account owner to purchase credits at participating colleges/universities for future tuition and fees at the current prices. These are limited to participating institutions and do not allow the owner to prepay for room and board; there is also no guarantee that the child will be admitted. There are typically residency requirements, and these types of plans do not cover elementary/secondary school expenses.

Despite these drawbacks, prepaid tuition plans can pay off when the cost of college increases more quickly than the market grows. There are also tax advantages: the equivalent of earnings on your investment is not subject to federal income tax if used for tuition and fees.

Prepaid tuition plans are only available in nine states at this time.

Education Savings Plans

Education savings plan allow the owner to open an investment account to save for qualified education expenses. Originally created to help people pay for college, it can also be used for K-12 education (as of 2017) and apprenticeship programs (as of 2019).

Qualified education expenses typically include tuition, fees, room and board, books, and computers/equipment associated with a student attending an eligible public, non-profit or private college/university or a technical, vocational or trade school. Tuition for public, private or religious elementary or secondary schools is also a qualified education expense, although the limit for non-higher education tuition is $10,000.

Because these are investment accounts, investors risk their money on the market in exchange for the possibility of returns.

The SECURE Act 2.0, passed in December 2022, allows up to $35,000 of unspent funds in a 529 plan that is at least 15 years old to be rolled into a Roth IRA account.*

Because education savings plans are the most common and widely-available form of 529 plan, the remainder of this article focuses on this type of plan.

Making Contributions to a 529 Plan

Anyone can set up a 529 account, but they are most often created by parents or grandparents on behalf of their child or grandchild, who is named as the beneficiary. You can open a 529 plan directly with your state or can work with a financial advisor or broker. States often charge a one-time account setup fee. Advisors or brokers may charge as much as 5% on the assets under management in the account.

Plan owners can open the ability to contributions to anyone; many grandparents or aunts/uncles may choose to make a contribution to a child’s future in lieu of toys for birthdays or holidays. Many 529 plan providers have online contribution options that make this easy.

There are no annual contribution limits. States may put a cap on how much you can contribute to the 529 plan in total, though these limits are quite high. Gift taxes do apply if an annual contribution is over the federal gift tax exclusion ($17,000 per donor in 2023).

Education expenses incurred by the plan beneficiary can be paid directly by the 529 plan, the owner can withdraw the amount and pay for the qualified expense or the owner can pay and submit for reimbursement. Whichever way money is withdrawn, the owner must provide documentation for all withdrawals on their federal income tax return to ensure the money was used for qualified expenses.

How Does a 529 Impact Financial Aid Eligibility?

529 plans do affect financial aid, but not to the degree you might think. Assets in a 529 are counted as the parents' assets on the Free Application for Federal Student Aid (FAFSA). When determining a child's Expected Family Contribution (EFC), which is the formula used to gauge financial aid, the percentage of parents' assets that'll be counted to pay for college expenses is capped at 5.64%. Depending on parental income, a 529 account may have little to no impact on a child's financial aid package. 

Contrast this with a savings account opened in the child's name. Because the account is owned by the child, the amount assessed as part of the EFC is 20%. 

Distributions from a 529 account receive favorable treatment on the FAFSA; qualified distributions that pay for the current year's college expenses aren't included in the base-year income calculation that could reduce college financial aid eligibility. 

Note that while most colleges follow the FAFSA formula for financial aid, some use their own formulas. It's a good idea to contact the schools under consideration to see which formula they use.

What Are the Tax Benefits of a 529 Plan?

One of the primary reasons people utilize 529 plans as a savings vehicle are because of the tax benefits. Contributions made to a 529 plan are done with after-tax dollars. These funds grow tax-deferred and can be withdrawn tax-free for qualified education expenses.

Contributions aren’t tax deductible on your federal income taxes, but more than 30 states offer state tax deductions and state tax credits for 529 plan contributions.

Making Changes to Your 529 Account

529 accounts are meant to be a longer-term savings vehicle, and you have some ability to make changes to the account structure after it’s been created.

Can I Change Ownership of a 529 Plan?

That depends on where you live – check your state 529 plan regulations. Many states allow you to change ownership of a 529 plan without requirements about the relationship between the former owner and the new owner. However, other states only allow a change of ownership if the original owner dies or in special circumstances like divorce.

If you are able to transfer ownership, you can typically do it penalty-free only once during a 12-month period. If you transfer again, it would be considered a nonqualified distribution and would incur a penalty and have federal income tax implications.

Can I Change the Beneficiary of a 529 Plan?

Naming a new beneficiary of a 529 plan is simple: the owner of the account fills out a form and submits it to the plan administrator. Sometimes there is an administrative fee that goes along with the change, but as long as the new beneficiary is a family member of the old beneficiary, there should be no taxes or penalties. According to the IRS, family members include children and their descendants, stepchildren, siblings, parents, stepparents, nieces, nephews, aunts, uncles, in-laws and first cousins. States can also impose additional restrictions, such as age and residency requirements.

529 transfer rules also allow you to split a 529 plan by creating a new account for an additional owner and rolling some funds from the old 529 into the new 529.

Can I Change My Investment Options?

One of the disadvantages of a 529 savings plan is the lack of investment control an account owner has. Participants in a 529 plan aren't allowed to direct the underlying investment decisions of the plan and have limited flexibility to change the investment option on their existing contributions.

At this time, owners can change the investment options twice per year or when there is a change in the beneficiary.

Owners can (and probably should) alter the asset allocation to more conservative mixes as the beneficiary approaches the time when they will need to access the funds to reduce the risk of significant loss.

Switching to a New 529 Plan

Not all 529 plans are the same. If you’re unhappy with your current plan’s investment performance or its perks, you can rollover to another 529 plan with the same beneficiary once per 12-month period year without penalty.

Is a 529 Plan Right for You?

529 plans aren’t the only dedicated college-savings vehicle, but they are a beneficial way to start preparing for the ever-increasing costs of higher education. Talk with a Farm Bureau agent or financial advisor about how to best manage all your financial priorities or how to start saving for college.