What Is a 529?

A 529 plan is a tax-advantaged account that helps investors stretch their college-savings dollars further. Saving a meaningful amount of money to pay for college is a heavy lift, and 529s have some big muscles that can help. 

First off, there are tax benefits: Contributions (money put into the account) are made with after-tax dollars, but once money is invested in the account, it grows tax-free, and withdrawals (money taken out of the account) are not taxed when the money is used for qualified educational expenses. 

Compared with other college savings vehicles, 529s have a more minimal impact on financial aid eligibility. On top of that, some states offer tax deductions or credits for contributions. 

What types of 529s are available?
There are two main 529 types: college-savings plans and prepaid tuition plans. 

College-savings 529s are the more popular and often better versions. They allow you to invest in stocks and bonds via preset investment menus. You can buy many yourself (direct-sold), and these are generally recommended because they’re cheaper. The remainder are sold by financial advisors; advisor-sold plans often have more investments but can be pricier because their expenses may include the cost of financial advice. 

Direct-sold and advisor-sold college-savings plans come in two main varieties:

Age-based: The portfolio automatically shifts from risky, higher-earning securities (stocks) to less-risky investments (bonds) as your child nears college. This helps protect your money from being wiped out in a market downturn shortly before you'll need to pay tuition bills. 

With some age-based plans, you can fine-tune the stock and bond exposure by choosing an aggressive (more equity) or conservative (less equity) track. Others let you choose between an active or passive portfolio. 

Static: The investment portfolio remains the same, or static, over time unless you manually adjust it. 

A static portfolio lets you cook your own college-savings meal using ingredients from a preset investment menu: stock funds, bond funds, and balanced funds, which contain a set proportion of stocks and bonds. 

Finally, prepaid 529s let you buy public in-state college credits at today’s price, meaning you’re not actually investing when buying these. Prepaid plans can have some benefits but come with various stipulations that often make them unappealing.

What are considered eligible expenses for 529s?
Withdrawals from a 529 account can be used to pay for tuition, mandatory fees, books, computers, and software (see Page 52 of this IRS publication for more). Room and board are included if a student is enrolled at least half the time. You can spend up to the amount the college lists for housing costs, provided in the cost of allowance budget. If your child lives off-campus, you can spend this amount on room and board. 

What happens if I take money out of a 529 for other reasons?
If you withdraw money for reasons not considered eligible expenses (see above), it could cost you dearly. A few important things to know:

• Withdrawals for nonqualified expenses usually incur a 10% penalty.
• You’ll owe applicable federal income taxes on earnings but not contributions, because 529 contributions are made with money that has already been taxed. (Withdrawals from 529s are pro-rata only, meaning they can't be entirely from contributions. For example, if your 529 account has $4,000 in contributions and $6,000 in earnings, withdrawing $1,000 taps $400 from contributions and $600 from earnings. 
• You could be on the hook to repay any state income breaks you received on those contributions.

What if my child doesn’t go to college or doesn't need all the money?
You can spend 529 funds for other educational purposes, like trade school, graduate school, and K-12 private education in many states. 

If these don’t help, or you have money left over, you can change the beneficiary, or the 529 account’s recipient, without tax consequences so long as:

• The new beneficiary is part of the original beneficiary’s family (rules on who constitutes a family member are very broad and include parents, siblings, some in-laws, first cousins, and stepsiblings).  
• The new beneficiary uses the funds for qualified educational expenses.