What Is a 529 Plan? A Guide to How a 529 Plan Works (2024)

A 529 plan provides a tax-advantaged way to invest for college and even for a private elementary and secondary school education. The money you contribute to a 529 plan isn't tax deductible for federal income tax purposes, but depending on where you live you may qualify for a state income tax deduction for contributions made to your home state plan. Investments in the 529 account have the potential to grow tax-deferred, and withdrawals, including any earnings, used to pay for qualified education expensesFootnote¹ are tax-free. Almost anyone can open and contribute to a 529 plan — there are no income restrictions — and 529 contribution limits are high enough to allow families to plan for the rising cost of college.

Withdrawals from a 529 plan are fully tax-free when used to pay for qualified education expenses. Those generally include anything a student needs to attend an accredited college, university or vocational or technical school — tuition and required fees, room and board,Footnote² books and equipment, and computer expenses, for example. Other qualified expenses include the costs associated with the participation in a certified and registered apprenticeship program; withdrawals of up to $10,000 per year to pay for tuition at an eligible private, religious or public K-12 school; and payments toward student loans of the beneficiary and each sibling of the beneficiary, up to a lifetime maximum of $10,000. This lifetime maximum applies separately to the account beneficiary and each sibling of the beneficiary.

While the rules cover a wide range of education costs, some expenses aren't considered qualified. Those include the cost of traveling to and from school, college test prep or entrance exam fees, health insurance purchased through the school and fees for extracurricular activities.

The earnings portion of non-qualified withdrawals is subject to federal and possibly state and/or local income taxes as well as a potential 10% additional federal tax.

Yes, you can open a 529 account for a grandchild. It doesn't matter where your grandchildren plan to attend school. Before you select a 529 plan, be sure to check for state tax or other state benefits available through your home state or your grandchildren's home state 529 plan. In addition, almost anyone can open a 529 plan, including friends and other relatives.

A 529 can also be an important estate planning tool. You can set up multiple 529 plans for your beneficiaries. If set up a 529 plan for one grandchild and that grandchild decides not to use the funds for college, you may be able to change the beneficiary to another grandchild (or certain other members of the original grandchild's family as defined in the Internal Revenue Code without incurring income taxes. With a 529 plan, you can also make a contribution of five times the annual gift exclusion amount in one year by filing an election on a federal gift tax return if certain conditions are met.Footnote³

Contributions made to a 529 plan generally are considered completed gifts and generally do not count as part of your federal taxable estate. However, if you are the account owner, you may still exercise control over the money, including choosing among the investments offered by the plan.

The short answer is yes — a child can be the beneficiary of multiple 529 plans. Why would parents or grandparents want to contribute to separate 529 plans? As noted in the previous question, state tax benefits may come into play if multiple individuals who reside in different states are contributing. Another reason is control: As the owner, the person who sets up a 529 plan can decide how the assets are invested and when distributions should be made. The owner can also change the account beneficiary, something you might want to do, for example, if the original beneficiary no longer needs the funds.

Although most 529 plans provide a diversified mix of investments to choose from, having more than one 529 plan could give you more investment options and access to additional investment managers. While not common, another reason for opening multiple 529s for the same beneficiary: contribution caps. Each state sets account balance maximums, which generally range from $300,000 to $550,000. The maximum applies to the combined balances of all accounts for the same beneficiary in that state's 529 plan. By opening an additional 529 plan in another state, you might be able to invest more than what your state allows.

You can move money from a custodial account, such as a UGMA (Uniform Gifts to Minors Act) or a UTMA (Uniform Transfers to Minors Act), to a 529 plan. There are two primary reasons to consider doing so. One is taxes. Investment earnings in a 529 grow tax-deferred, and withdrawals, including any earnings, are tax-free when they are used for qualified education expenses. In a custodial account, investment income over a certain threshold may be taxable. The second reason is that 529 assets are treated more favorably from a federal financial aid perspective than UGMA or UTMA assets. When applying for federal financial aid, since 529 assets are generally considered parental assets, only 5.64% of which are considered when calculating the new Student Aid Index (which replaces the existing Expected Family Contribution), while UGMA/UTMA assets, which are considered the student's assets, are factored in at 20% for purposes of the federal financial aid calculation. (See more below).Footnote⁴

There are a few downsides to this shift, however, including potential capital gains taxes on any profits when you sell UGMA or UTMA assets to make the transfer. Plus, when you transfer a custodial account to a 529, you create what's called a custodial 529 account, which has certain restrictions. For one, you cannot change the beneficiary, as you can with a traditional 529, and it is your obligation to turn the assets over to the designated beneficiary when they reach the termination age based on the state the UGMA or UTMA was established under.

Within any 12-month period, IRS rules allow one tax-free rollover of a single 529 account into another 529 account for the same beneficiary. Two reasons you might consider a rollover: You've moved, and your new state offers a tax deduction for contributions to qualifying in-state 529 plans. By rolling the 529 from your old state into your new home state's plan, you can keep new and old contributions together in one account. Or you may have multiple 529s for other reasons and want to consolidate them to make tracking and managing your savings easier. Finally, you can roll a 529 account into another 529 account for a member of the family of the designated beneficiary.

The financial aid formulas used to determine need-based federal grants, loans and scholarships treat assets and income differently, with assets playing less of a role than income does. Parents are typically expected to contribute only 5.64% of assets annually toward college, including 529 plans (but not including retirement savings or the equity in your primary residence).

Students are expected to chip in 20% of their assets for college costs, including UTMA and UGMA custodial accounts — making a 529 plan a better savings choice if aid eligibility is a priority. Starting with the 2024-25 school year, you will not be required to report a 529 owned by a grandparent on the FAFSA (Free Application for Federal Student Aid), so those assets won't figure into aid formulas. (Keep in mind, however, that some private colleges use different financial aid forms that may treat 529s differently.)

Financial aid rules may change, and the rules in effect at the time the beneficiary applies may be different. For more information on federal aid, please go to the Department of Education's website at www.ed.gov.

If your child doesn't go to college or doesn't need all the 529 funds, perhaps due to scholarships, you have a few options for using what's left. One is to transfer or roll over the 529 account to a new beneficiary. To be an income tax-free rollover, that person must be a member of the original beneficiary's family, such as siblings (including stepsiblings), parents, spouse, children, first cousins, nieces and nephews. You can also name yourself as a beneficiary (assuming you are a family member of the beneficiary) and use the funds for your own education or training, either in your current career or as a way to begin a new one. This strategy isn't possible, however, for custodial 529 plans — as that beneficiary designation is irrevocable.

If your child receives a scholarship, grant or attends a U.S. military academy, you may withdraw an amount equal to the scholarship/grant (or the costs of advanced education attributable to attendance at the military academy) from the 529 account without having to pay the 10% additional federal tax; you will owe only the federal ordinary income taxes on the earnings portion of the withdrawal. State and local income taxes may also apply. The 10% additional tax is also waived if the beneficiary dies or becomes disabled. You can also roll over a 529 into an ABLE account (a tax-advantaged savings account that benefits those who are disabled), subject to ABLE contribution limits. Beginning in 2024, you can also roll over 529 assets to a Roth IRA for the beneficiary if the 529 account has been open for at least 15 years and meets certain other conditions.

Also keep in mind that there aren't any distribution deadlines on 529 account assets, so assets can remain in an account and be used to fund the beneficiary's graduate or other schooling at a later date. Finally, you can close the account and take a non-qualified withdrawal. In that case, federal income taxes, state and local income taxes, and the potential additional 10% federal tax on earnings will apply.