Paying for college typically requires students and families to draw from a number of funding sources. Per a Sallie Mae survey, on average, parents and students’ income and savings covered 54% of college costs during the 2021–2022 academic year, with scholarships and grants, loans, and money from family and friends taking care of the remainder. As you put money away for college, your first instinct may be to open a savings or brokerage account. But there’s another option created for this specific scenario: a 529 plan.
Also known as a Qualified Tuition Plan, a 529 plan is a tax-advantaged investment account designed to help people save for education costs. These plans, named after Section 529 of the tax code, are sponsored by states or state agencies (as well as the District of Columbia). Let’s take a closer look at how these plans work.
What are the tax advantages of a 529 plan?
Similar to a Roth IRA or a Roth 401(k), contributions to a 529 plan are made using post-tax dollars. Therefore, your investment grows tax-deferred and can later be withdrawn tax-free for qualifying education expenses. Additionally, many states offer state-income tax deductions or credits for contributing to a 529 plan.
These tax benefits can help maximize your savings when compared to a traditional savings or investment offering. However, since a 529 plan is an investment account, your balance may increase or decrease depending on portfolio performance.
What counts as a qualified expense?
Under a 529 plan, qualified expenses include items listed in a college’s cost of attendance, such as tuition and fees, room and board, as well as books and computers. You can also use up to $10,000 to repay your student loans.
Only withdrawals for eligible expenses will be tax-free, whereas other non-qualified withdrawals will be taxed—and you’ll be charged a 10% penalty.
What if I don’t use all the money in the plan?
Good news: recent changes under the Secure 2.0 Act allow 529 plan beneficiaries to rollover unused funds into a Roth IRA both tax and penalty-free! To do so, your plan must have been open for at least 15 years and the beneficiary must meet the income eligibility requirements for a Roth IRA. Rollovers are still counted towards yearly contribution maximums and the total rolled over amount cannot exceed $35,000.
This change can help you save more confidently by providing an option that allows your unused funds to continue to benefit from tax advantages. It’s also a great backup plan in the event your child receives a large scholarship, decides not to attend college, or you happen to oversave.
To learn more about how much you should be aiming to save in a 529 plan, check out our College Savings Planner.