What Is a 529 Plan?

If there’s one thing we can all agree on, it’s that a college education is expensive. And although student loans are advertised as the easiest way to pay for college, they’re actually a huge burden on your financial future. That’s why it’s important to plan for your children to go to college debt-free. (And yes—it’s totally possible!)

In addition to choosing an affordable school and applying for scholarships, a great way to avoid student loans when sending your kid to college is saving and investing money ahead of time. And one of the best options for that is a 529 plan.

So, let’s dig into all that 529 plans have to offer.

• What Is a 529 Plan?
• How Does a 529 Plan Work?
• Types of 529 Plans
• 529 Plan Tax Benefits
• Should I Invest in a 529 Plan?

A 529 plan (named after its section of the IRS tax code) is an investment account that allows you to set money aside for qualified educational expenses—think things like tuition, fees, books, and room and board. The setup for 529 plans varies between states, and the plans are managed by state treasury departments.

Each 529 plan has an account owner (typically a parent) and a beneficiary (the student). Most people associate these plans with saving money for their kids’ college education, but you can set up a 529 to pay for your own education. And you can even use the money in some 529 plans for K–12 tuition and apprenticeship programs too.

There are no annual contribution or income limits for 529 plans. Anyone can contribute to a 529 plan—including parents, grandparents, aunts and uncles. They will, however, have to pay a gift tax if they contribute more than $17,000 in a single year as an individual.

Most states’ 529 plans do have limits for the total money that can be saved and grown in the account, but they’re typically pretty high—we’re talking six figures.

Once you put money into a 529, you can invest it so it can start growing. 529 plans use after-tax dollars, meaning any money you put in comes from your net take-home pay. And here’s the wonderful news: All of the money you contribute to a 529 grows tax-free! 

Unlike other types of investment accounts, not all 529 plans are made the same. There are lots of different types of 529 plans, but we’re going to focus on the two major plans you should know about: prepaid plans and savings plans.

Prepaid Plans

Prepaid 529 plans offer you something that sounds really special: the ability to prepay for future college expenses at the current tuition rates. Basically, you agree to pay for a certain amount of college tuition at the current rate, either in one large payment or through an installment plan, and the plan administrator will invest the money for you. Then, when your child is ready to head off to campus, you can begin withdrawing money from the plan to pay for their tuition—and most prepaid plans guarantee you’ll have enough to cover the costs.

That seems like a great deal, right? Well, it turns out that prepaid 529 plans aren’t a good deal after all. Here’s why.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

First, prepaid plans have a lot of restrictions, starting with how you can use the money. You can only use the money on college tuition and fees—paying for books or housing is off the table. Some prepaid 529 plans also place restrictions on which schools you can use the money at, and they limit enrollment to a small window each year. Plus, many prepaid 529 plans have strict eligibility requirements for the beneficiary’s age and grade. Talk about picky!

And on top of all those restrictions, getting to prepay for tuition at current rates isn’t as much of a bargain as you may think. While it’s true that in-state tuition and fees at public universities have averaged an annual growth of 8.75% over the last 20 years—which is a lot—you can get more bang for your buck by investing in good growth stock mutual funds.¹ Historically, mutual funds have averaged an even higher growth than college tuition—around 10–12%.²

Do you see how investing in prepaid 529 plans isn’t a great idea? Not only do you have to deal with a bunch of red tape, but you can also make more money over time with other, better investment options.

Luckily, there’s another type of 529 plan that’s a much better deal.

Savings Plans

Just like the name says, a 529 savings plan is a place for you to save money for education expenses. It’s a tax-advantaged investment account, and it’s got some cool features, like:

• Each savings plan varies from state to state, and you don’t have to use your state’s plan. You can go with the most affordable option!
• There’s no age limit for contributions or distributions. If your 30-year-old decides to go back to school, they can still use the money left over in the account.
• If you don’t use the money for one child, you can transfer the funds to another child or grandchild.
• If you want to use money in a savings plan for noneducational expenses, you can. It’s your money! But you will have to pay taxes and a 10% penalty. 

Plus, starting in 2024, beneficiaries of 529 savings plans will be able to roll over any unused money into a traditional or Roth IRA after 15 years. That means, if your child has money left over in the account after going to college (or if they don’t go to college at all), they can use it to get a jump start on saving for retirement. Pretty sweet, huh?

So, how do you choose a 529 plan? Step one is to steer clear of prepaid plans. Because, in case you forgot, prepaid plans aren’t a very good idea. You need to choose a 529 savings plan.

As you decide which savings plan to pick (and there are a few bad ones out there), make sure you choose one that puts you in the driver’s seat. While 529 plans won’t let you choose individual investments, you do want to pick one that gives you control over which portfolios you invest in.

You should avoid 529 savings plans that require you to lock in or freeze your portfolio choices, because that keeps you from changing them down the road. You also want to stay away from plans that automatically adjust your portfolio choices based on the age of the beneficiary (sometimes called a “life phase” 529 plan).

Again, you need to be in charge, not someone else. Your money, your rules.

Like we talked about earlier, 529 plans use after-tax dollars, and they grow tax-free. That means, when you withdraw money from your 529 to use on qualified expenses (including college or K–12 tuition), you won’t have to pay any taxes. That’s a big deal, folks!

How big? Let’s take a look. If you put $250 a month into a 529 from the time your child turns 5 until they turn 18, you will have contributed $39,000. Invested in good mutual funds with a 10% rate of return over those 13 years, that amount would grow to nearly $80,000—a growth of almost $40,000! And here’s the best part: You would pay zero taxes on that $40,000. 

In that scenario, the tax benefits of a 529 plan would save you thousands of dollars. And that’s a huge advantage, since every dollar counts when you’re saving for college.

Yeah, we could get used to this whole “tax-free” thing.

A 529 plan is a great place to invest money for you or your kids to go to college, but it isn’t for everyone. You shouldn’t invest in a 529 plan if you aren’t financially ready to do so.

Saving for your kids’ college is a great financial goal, but it may not be the most important goal for you right now. If you have consumer debt—like a credit card balance, a student loan or a car payment—focus on paying that off first. Once you’ve paid your debt off, you should work toward building an emergency fund worth 3–6 months of your typical expenses. Then, start investing 15% of your income into retirement accounts like a 401(k) or a Roth IRA.

Accomplishing those goals before investing in a 529 plan will set you up with a really strong financial foundation, and it will make reaching your investing goals a whole lot easier.

Don’t Invest for College on Your Own

Whatever decision you make about investing for education expenses, you shouldn’t make it alone. Like the Bible says in Proverbs 11:14 (NKJV), “Where there is no counsel, the people fall; But in the multitude of counselors there is safety.”

Getting an investment professional on your side is a great way to give yourself that safety. They can bring knowledge and expertise to the table and guide you through investing decisions like how to save for education.

Find a Financial Advisor

For help finding a financial advisor in your area, check out SmartVestor. It’s a free program that’ll connect you with financial advisors who can help you make informed investing decisions about college savings plans.

Get connected with a SmartVestor Pro today!

Ramsey Solutions is a paid, non-client promoter of participating pros. 

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.