How does a 529 plan work?

Curious about how a 529 plan works? If you want to save money for your child’s college education in the future, a 529 plan is an account that can help you with that. Read more about how it works and if it’s right for you.

What does a 529 plan do?

A 529 plan is a tax-advantaged savings plan designed to help individuals save for future college expenses. Here’s how it works:

1. Account Setup: The account holder (usually a parent or grandparent) opens a 529 plan account and designates a beneficiary (the student who will use the funds for college expenses).
2. Contributions: The account holder can then make contributions to the account, which are invested in a portfolio of mutual funds or other investments offered by the plan. The contributions are made with after-tax dollars, meaning that they are not tax-deductible at the federal level, but some states may offer state tax deductions for contributions.
3. Tax Advantages: The earnings on the investments in the account grow tax-free, meaning that you do not have to pay taxes on the gains as long as they are used for qualified educational expenses. Qualified expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution.
4. Withdrawals: When the beneficiary attends college, the account holder can make withdrawals to pay for qualified educational expenses. These withdrawals are not taxed at the federal level, and some states also offer tax benefits.

It’s important to note that if you withdraw money from a 529 plan for non-qualified expenses, you will be subject to federal income tax and a 10% penalty on the earnings portion of the withdrawal. However, the contributions can be withdrawn tax-free and penalty-free at any time.

Who should save under a college 529 plan?

A college 529 plan can be a good savings option for anyone who wants to save for a beneficiary’s future college expenses. Here are some common scenarios in which a 529 plan might be a good choice:

1. Parents: Parents who want to save for their child’s college education can open and contribute to a 529 plan. They can start contributing as soon as their child is born, giving the investments more time to grow.
2. Grandparents: Grandparents can also open and contribute to a 529 plan for their grandchildren. This can be a way for them to help pay for their grandchildren’s education while also reducing their own estate for tax purposes.
3. Other family members: Aunts, uncles, and other family members can also open and contribute to a 529 plan for a beneficiary.
4. High-net-worth individuals: High-net-worth individuals who want to make a large contribution to a beneficiary’s education fund can use a 529 plan as a tax-efficient way to do so.

It’s important to note that 529 plans have contribution limits, which vary by state and can change over time. It’s also important to consider other savings options, such as a Coverdell Education Savings Account or a custodial account, and to consult with a financial advisor to determine the best savings strategy for your situation.