Complete Guide to 529 Plans: What It Is and How They Work

Complete Guide to 529 Plans: What It Is and How They Work

By
Craig Austad
and
|
May 1, 2025

Like many people, you might feel overwhelmed if you’re trying to save for your or your child’s education. A 529 can ake much of the stress and confusion off of your shoulders. This tax-advantaged savings plan helps you set aside money for future education costs. Are you planning for a child’s college tuition or K-12 expenses? Maybe you’re even looking at apprenticeship programs. A 529 plan offers valuable benefits regardless, including tax-free growth and withdrawals for qualified expenses.

The cost of education is always rising. As such, 529 plans have become a key part of education and financial planning. Many parents and grandparents use them to invest in a child’s future while taking advantage of some state tax benefits. But how exactly does it work? Let’s break down the essentials.

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Understanding 529 Plans: The Basics

What is a 529 plan and how does it work?

A 529 plan is a tax-advantaged savings account for educational expenses. Your contributions grow tax-free, and withdrawals for qualified education expenses (tuition, books, room and board) are also tax-free.

A 529 plan is a powerful tool for education savings, but how does it work? Whether you’re just starting to explore your options or looking to fine-tune your education planning, it’s important to understand the basics.

What Exactly is a 529 Plan?

A 529 plan is a state-sponsored education savings account designed to help families save for school expenses. The money you contribute grows tax-free. If you use it for qualified education expenses, such as tuition, books, or room and board, you won’t pay taxes when you withdraw it.

Most people think of 529 plans for college savings. However, they can also be used for K-12 tuition, apprenticeship programs, and student loan repayments. Each state offers its own 529 plan. While you’re not necessarily limited to your home state’s plan, some states may provide tax benefits for residents who contribute to theirs.

How Does a 529 Work?

Opening a 529 account is simple. You choose a plan (typically offered by a state or financial institution), contribute money, and invest those funds in mutual funds or age-based portfolios. Then, the money in the account grows tax-free. When it’s time to pay for qualified education expenses, you should be able to withdraw it without tax penalties.

Most 529 plans allow anyone to contribute, including parents, grandparents, and friends. No annual contribution limits exist, but large deposits may be subject to gift tax rules. Some states may also offer tax deductions or credits for contributions.

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Types of 529 Plans

Not all 529 education savings plans work the same way. There are two main types: prepaid tuition plans and education savings plans. Both help you set aside money for future education costs, but they operate differently.

Prepaid Tuition Plans

A prepaid tuition plan lets you lock in today’s tuition rates for future college expenses. These plans are typically state-sponsored and allow families to pay for credits at participating public colleges and universities in advance.

Key Features:
  • Tuition Protection: Lock in current tuition rates, avoiding future price increases.
  • State-Backed Security: Some plans may offer a guarantee by the state, which may reduce investment risk.
  • Tax Advantages: Like other 529 plans, earnings grow tax-free when used for qualified expenses.

Potential Drawbacks:
  • Prepaid tuition plans don’t cover expenses like room and board.
  • These plans are usually limited to in-state schools (though some offer conversion options for out-of-state colleges).
  • This plan might be best if you’re confident your child will attend a participating school.
Education Savings Plan

A 529 savings plan works more like an investment account. You contribute money, choose investment options (such as mutual funds or age-based portfolios), and let the funds potentially grow over time. Unlike prepaid tuition plans, savings plans can be used for any qualified education expense—including tuition, fees, books, room and board, and even K-12 private school tuition.

Key Features:
  • Flexibility: Funds can be used at most accredited colleges, universities, and some international schools.
  • Investment Growth: The account’s value depends on market performance, offering opportunities for long-term or short-term growth strategies.
  • Tax Advantages: Earnings grow tax-free, and withdrawals for qualified expenses aren’t taxed.

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Benefits of 529 Plans

A 529 is one way to save for education and it comes with valuable perks. Some examples include tax breaks and flexibility. These plans may make it easier for families to grow an education investment fund while controlling how the money is used. Let’s explore these benefits in more detail.

Tax Advantages

One of the biggest 529 benefits is the tax savings. Your contributions grow tax-deferred, meaning you won’t pay taxes on earnings as the account balance increases. When it’s time to withdraw funds for qualified education expenses, those withdrawals are completely tax-free at the federal level. They may be tax-free at the state level as well. 

Some states even offer tax deductions or credits for contributions, making it an even better deal. Unlike other education savings options, a 529 plan is designed to let your money grow without getting chipped away by yearly taxes. This lets you build a bigger fund for future education costs.

Flexibility and Control

Unlike other savings accounts, you stay in full control of the funds. That means you, not the student, decide when and how the money is used. You can easily change the beneficiary to another family member without penalty if the original beneficiary doesn’t need the funds. 

This flexibility also extends to how the funds are used. A 529 plan covers various education costs, from K-12 private school expenses to apprenticeship programs to student loan payments. Plus, there’s no age limit. The money can be saved and used whenever it’s needed.

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Potential Downsides and Risks

What is the downside of a 529 plan?

Limitations include restricted use of funds, investment risks, and penalties on non-qualified withdrawals.

529 plans offer great benefits, but they’re not for everyone. Like any investment, they have rules, restrictions, and potential drawbacks. Here are some factors to consider before opening an account.

Limitations and Restrictions

  • Qualified Expenses Only: Withdrawals must be used for qualified expenses (tuition, fees, books, etc.). You'll face taxes and penalties if you use the money for something else.
  • Market Risk (Savings Plans): If you choose a 529 savings plan, your investments can fluctuate with the market. This means there’s potential for losses.
  • Prepaid Tuition Limitations: Prepaid tuition plans are typically tied to in-state public colleges, which may not work if your student chooses a different school.

Penalties for Non-Qualified Withdrawals

Penalty Type Details
Taxes on Earnings The growth portion of your withdrawal is subject to federal and state income tax.
10% Penalty A 10% penalty applies to the earnings portions of the withdrawal.
State Tax Clawbacks If your state offered tax deductions on contributions, you may have to pay those back.

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Limited Investment Choices

Unlike other investment accounts, a 529 plan only offers pre-selected investment options. Usually, it’s a mix of mutual funds or target-date portfolios. Also, you can’t pick individual stocks and are typically limited to changing your investment strategy twice a year.

Impact on Financial Aid

While 529 plans don’t count as student assets (which is good), they do count as parental assets on the Free Application for Federal Student Aid (FAFSA). This can reduce the amount of need-based aid a student qualifies for.

Bottom Line

529 plans are one way to save for education tax-free. However, they do have rules. If you’re unsure whether one is right for you, consider how much flexibility you need and if you’re comfortable with the restrictions on non-education withdrawals.

How to Open and Start a 529 Plan

Starting a 529 plan is easier than you might think. Here’s a step-by-step guide to get started.

Step 1: Choose the Right Plan

Each state offers its own 529 plan, but you’re not necessarily limited to using the one where you live. Some states provide tax benefits for residents. Others may offer better investment options. Compare different plans to find one that fits your needs.

Step 2: Pick the Account Owner and Beneficiary

  • The account owner (usually a parent, grandparent, or guardian) controls the funds.
  • The beneficiary is the student who will use the money for education.
  • If the beneficiary doesn’t need the funds, you can transfer the account to another family member without penalty.

Step 3: Open the Account

You can open a 529 plan directly through the state’s plan website or a financial institution. The process is similar to setting up a regular investment account. You just need to provide basic personal information and choose your funding method.

Step 4: Choose Your Investment Option

529 plans offer a range of pre-set investment choices, including:

  • Age-Based Portfolios: Automatically adjust risk levels as the beneficiary approaches college age.
  • Static Portfolios: Maintain the same investment mix over time.
  • Individual Fund Options: Let you build your own mix of investments (varies by plan).

Step 5: Start Making Contributions

  • Most plans let you start with as little as $25-$50.
  • There’s no annual contribution limit, but large contributions may be subject to gift tax rules.
  • Some states offer tax deductions or credits for contributions.

Step 6: Set Up Automatic Contributions (Optional)

To make saving easier,  consider setting up automatic transfers from your account. Even small, regular contributions can add up over time. 

Step 7: Monitor and Adjust as Needed

529 plans allow you to change your investment choices twice yearly, so check in periodically to ensure your plan still matches your goals.

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Funding Your 529 Plan: Contribution Guidelines

How much is $100 a month in a 529 for 18 years?

At a 6% average return, contributing $100 a month for 18 years could grow to about $38,000. Actual growth depends on market performance and investment choices.

Once you’ve chosen a plan and opened an account, the next step is determining how to contribute and when. Do you want to make small, regular deposits? Or will you make a large deposit upfront? Understanding 529 contribution rules can efficiently help grow your kids’ college fund and avoid unintended tax consequences. 

Annual Contribution Limits

While there’s no federal cap on how much you can contribute to a 529 plan each year, understanding gift tax implications is a must:

  • Annual Gift Tax Exclusion: In 2025, you can contribute up to $19,000 per beneficiary without triggering gift taxes. For married couples filing jointly, this exclusion doubles to $38,000. 
  • State-Specific Limits: Each state sets its own aggregate contribution limits for 529 plans, ranging from $235,000 to $575,000. It’s crucial to check your state’s specific limits to ensure compliance.

Frontloading Contributions

If you’re considering jump-starting your child’s education savings, frontloading (i.e. making a large initial contribution) can be an effective strategy:

  • Five-Year Election: The IRS allows you to treat a lump sum contribution as if it were spread over five years. For 2025, this means your contribution up to $95,000 per beneficiary ($19,000 x 5) in one year does not incur gift tax, provided no additional gifts are made to the same beneficiary during this period. Married couples can jointly contribute up to $190,000 under this rule.
  • Benefits of Frontloading: In theory, a larger initial investment has more time to grow, taking advantage of compound interest. Also, frontloading can reduce the size of your taxable estate, offering potential tax benefits.

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Maximizing Your 529 Savings Plan

A 529 plan is an investment in the future.. Whether focused on long-term education and financial planning or estate planning, these strategies will get you the most out of your savings.

Investment Strategies

Growing your 529 plan balance means choosing the right investment approach. Here are some best practices:

  • Start Early: The sooner you begin contributing, the more time your money has the opportunity to grow through compound interest and long-term objectives.
  • Consider Age-Based Portfolios: Many plans offer portfolios that automatically adjust from aggressive (more stocks) to conservative (more bonds) as the beneficiary nears college age.
  • Diversify Investments: If you prefer a more hands-on approach, mix stocks and bond funds to help balance growth and stability.
  • Make Regular Contributions: Consistent deposits, whether monthly, quarterly, or annually, help build savings over time.
  • Take Advantage of Tax Benefits: Some states offer 529 tax deductions or credit. Make sure you’re getting all available perks.

Minimizing Risk

While 529 plans offer tax-free growth, they’re still subject to market ups and downs. Here’s how to protect your investments:

  • Adjust Risk Based on Timelines: Growth-focused investments (stocks) may make sense if college is still a decade away. As the beneficiary gets closer to school, shift to more stable options (such as bonds or cash).
  • Monitor and Rebalance: Check your investment allocations annually to ensure they still match your goals.
  • Know Your States’ Plan Rules: Some states have stricter withdrawal rules or less attractive tax benefits. Choose wisely.
  • Have a Backup Plan: If your original beneficiary doesn’t need the funds, you can potentially transfer the 529 to another family member without penalties (this may vary by plan).

Special Uses for 529 Plans

We’ve mentioned the flexibility involved with 529 plans. These plans offer more options than you might think, from studying abroad to paying off student loans. Here are some unique ways to use your 529 education savings.

Study Abroad

A 529 can cover expenses at many eligible international schools. If the school is accredited and participates in the U.S. Department of Education’s financial aid program, you can use your funds for tuition, fees, and living expenses.

Paying Off Student Loans

A lesser-known benefit of 529 plans is that they can be used to pay off student loans, up to $10,000 per beneficiary. This includes federal and private student loans. Also, if you have leftover funds, you can apply another $10,000 toward student loan debt for each of the beneficiary’s siblings.

UTMA/UGMA 529 Plan

If you originally saved for a child’s education using a UTMA or UGMA custodial account, you can transfer those funds into a 529 plan for additional tax advantages. The main difference? A UTMA/UGMA 529 plan still belongs to the child once they reach adulthood, meaning they’ll gain full control over funds.

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What Happens if Your Child Doesn’t Go to College?

What happens to a 529 if my child doesn’t go to college?

You can transfer the account to another family member, use it for trade schools or apprenticeships, or withdraw the funds (with taxes and a 10% penalty on earnings, unless an exception applies).

If your child doesn’t take the traditional college route, your 529 plan funds don’t have to go to waste. You have several options:

  • Change the Beneficiary: You can transfer the account to another family member, including siblings, parents, or yourself, without penalties.
  • Use It for Alternative Education: Funds can cover apprenticeship programs, trade schools, and K-12 private tuition.
  • Pay Off Student Loans: Up to $10,000 per beneficiary (plus an additional $10,000 for each sibling) can be used to repay student loans.
  • Withdraw the Money: If used for non-education expenses, earnings are subject to income tax and a 10% penalty, though the penalty is waived if the child gets a scholarship (up to the scholarship amount).
  • Save It for the Future: 529 plans don’t expire. You can keep the account open for future education needs.

Using a Single 529 for Multiple Children

One 529 plan can benefit multiple kids by transferring funds to another qualified family member if needed without penalties. This family member could be a sibling, step-sibling, parent, or yourself.

How Transfers Work

  • The account owner stays in control and can change the beneficiary anytime.
  • There’s no transfer limit as long as the new beneficiary is a qualified relative.

Factors to Consider

  • State Tax Rules: Some states may require repaying past tax deductions if you switch beneficiaries.
  • Financial Aid Impact: A transferred 529 may affect the new beneficiary’s FAFSA eligibility.
  • Investment Adjustments: If switching to a younger child, you may need to rebalance the portfolio.

Withdrawing Funds: Rules and Considerations

When it’s time to use your 529 savings, knowing the withdrawal rules helps avoid taxes and penalties. Qualified withdrawals are tax-free. Non-qualified withdrawals come with extra costs. Planning ahead ensures you get the most from your savings.

Qualified vs. Non-Qualified Withdrawals

Qualified withdrawals (tax-free):

  • Tuition, fees, books, supplies
  • Room and board (for students enrolled at least half-time)
  • Student loan payments (up to $10,000)
  • K-12 tuition (up to$10,000 per year)

Non-qualified withdrawals (taxed + penalties):

  • Any expense not related to education
  • Earnings portion subject to income tax + 10% penalty
  • Exceptions: If your kid gets a scholarship, attends a U.S. military academy, or becomes disabled, the penalty is waived (but earnings are still taxed).

Why Work with a Financial Advisor for Your 529 Plan?

A 529 plan might be a great way to save for education, but choosing the right strategy can be difficult. A financial advisor can help you:

  • Maximize tax benefits and ensure you take advantage of state incentives.
  • Select the right investments based on your child’s age and risk tolerance.
  • Plan withdrawals wisely to avoid taxes and penalties.
  • Optimize estate planning for large contributions.

Education is a big investment. Working with a Savvy advisor can help get you the most out of your 529 plan.

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author
Craig Austad, CLU®, CFP®

Craig Austad has been in the financial services industry for over 25 years, and his passion lies in helping individuals take control of their finances. He has extensive experience working with clients and uses this knowledge to manage his practice. He wears many hats at the firm, but his most important job is helping his clients make sound decisions about their assets. He believes it is rewarding to develop effective strategies for his clients to help them achieve their goals. Craig is a CERTIFIED FINANCIAL PLANNER™ professional and takes his industry education seriously. He is also a Chartered Life Underwriter™ and proud member of the Financial Planning Association of Colorado. When not in the office, he can be found in the mountains skiing with his wife and two kids, getting together with friends and family, and enjoying all that Colorado has to offer.

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Material prepared herein has been created for informational purposes only and should not be considered investment advice or a recommendation.  Information was obtained from sources believed to be reliable but was not verified for accuracy.  Some states do not conform with federal tax law. Please check with your home state to determine if it recognizes the expanded 529 benefits afforded under federal tax law, including distributions for elementary and secondary education expenses, apprenticeship programs, and student loan repayments. You may want to consult with a tax professional before investing or making distributions.  Please carefully consider the plan's investment objectives, risks, charges, and expenses before investing.  All advisory services are offered through Savvy Advisors, Inc. (“Savvy Advisors”), an investment advisor registered with the Securities and Exchange Commission (“SEC”).

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Craig Austad is an investment adviser representative with Savvy Advisors, Inc. (“Savvy Advisors”).  Savvy Advisors is an SEC registered investment advisor. The views and opinions expressed herein are those of the speakers and authors and do not necessarily reflect the views or positions of Savvy Advisors.  Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy.

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