About 529 plans: Education savings with tax benefits

A man who is helping his daughter with her future education by setting up a 529 plan.

If you’re like many parents, you’re putting away money for your kid’s education as you save for retirement. A 529 plan can be a great way to do it—while taking advantage of tax benefits, flexibility, and more.

Choose from 2 types of 529 plans

There are 2 types of 529 plans, which vary by state.

1. 529 college savings plans

529 college savings plans allow greater flexibility in how and where your school savings funds can be used, allowing for expenses such as mandatory fees, room and board, and textbooks, without designating a particular school. These plans are more common and more flexible.

2. 529 pre-paid tuition plans

529 pre-paid tuition plans allow the parent, grandparent, or others to prepay tuition at today’s rates at eligible public and private colleges and universities, locking in tuition prices ahead of time. You pay for amounts of tuition (in years, credits, or units) in one lump sum or through installments.

Some plans offer contracts for a 2-year community college or a 4-year undergraduate program, or a combination, and can cover 1-5 years of tuition. (Some plans even allow the contract to apply to graduate school tuition.) Residency restrictions may apply. Visit savingforcollege.com to learn more about 529 prepaid tuition plans.

It's worth doing your homework to see what works best for your student.

"You should fully understand a plan before signing up, including its tax benefits and investment options," says Heather Winston, CFP®, assistant director of financial advice and planning at Principal®.  “You can open a 529 plan offered by any state, so it’s good to shop around for the one that best suits your needs.”

Basic 529 plan benefits and features

  • Your contributions aren’t deductible on federal taxes, but the earnings grow on a tax-deferred basis. More than 30 states offer a full or partial tax deduction or credit for 529 plan contributions. (Research your state’s tax treatment.)
  • Withdrawals are exempt from federal taxes when used for qualified expenses1 such as tuition, books, certain computer-related expenses, and sometimes room and board costs. To learn more, read the Q&A on the IRS website.
  • It’s not just for college. As of 2018, up to $10,000 can be withdrawn tax-free from a 529 plan per year, per beneficiary, for tuition expenses at public, private, or religious schools for grades K-12.
  • You can use your 529 plan at more than 6,000 U.S. 4-year colleges and universities, trade schools, and community colleges, and more than 400 foreign colleges and universities. (Find out if your school is eligible under 529 plan rules.)
  • You have flexibility to change beneficiaries. If one child chooses not to go to college, you may “roll over” the funds to another child or grandchild—even for yourself if you’re going back to school.
  • As the donor, you have full control of the account and funds until they’re withdrawn.
  • Assets in a 529 plan may or may not count when calculating financial aid for the beneficiary (the child). It depends on who owns the account. It’s complicated, so do some research.
Graphic of a thumbtack. Tip: Tax rules for college savings options can be complicated. Before investing, you may want to consult your tax advisor about any potential tax benefits and consequences.

How 529 plan rules vary by state

  • Lifetime 529 contribution limits may vary by state, ranging from $235,000 – $520,000.
  • Any state tax advantages (or other state benefits) can vary and may depend on whether you’re a resident of the state that sponsors the plan.
  • Most plans offer age-based investments that become more conservative over time as the beneficiary gets closer to withdrawing funds to pay for qualified educational expenses.
  • Investment options vary a lot, ranging from higher risk stock funds, to funds that have a mix of stocks and bonds, to conservative investments that have money market or conservative short-term bond funds or CDs.
  • Most importantly: Fees and expenses vary greatly, even among plans offered within the same state. (Yes, some states have more than one 529 plan!)

4 ways to make the most of your college savings plan

  1. Start early and add to it often. Consistency is key to a successful college savings plan, says Winston. She suggests contributing to the account on a monthly basis to stay on track, and to start as early as possible so you have the power of compounding on your side.
  2. Review your plan regularly. Winston suggests looking at your 529 plan each year and adjusting as needed based on your budget, a change in income, or an expanded family.
  3. Look at the 529 savings plan(s) for your state first. You may find state tax breaks or fees that are waived or lowered for in-state residents.
  4. Talk to a financial advisor about all the choices available to you for college savings. If you don’t have an advisor, we can help you find one near you.

Winston’s last suggestion is for Mom and Dad: “Save for retirement first and college second," says Winston. "You may be able to take out loans for education, but not for retirement." (To learn more, read: Help the kids? Or save for retirement?)

Next steps

1 Earnings on nonqualified distributions (those that don't meet the requirements of qualified expenses) are taxed as ordinary income and may be subject to a 10% federally-mandated penalty.

This document is intended to be educational in nature and is not intended to be taken as a recommendation.

Investing involves risk, including possible loss of principal.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Securities offered through Principal Securities, Inc., 800-547-7754, member SIPC and/or independent broker-dealers. Investment advisory products offered through Principal Advised Services, LLC. Principal Life, Principal Securities, and Principal Advised Services are members of the Principal Financial Group®, Des Moines, Iowa 50392.

Principal, Principal and symbol design, and Principal Financial group are trademarks and service marks of Principal Financial Services, Inc, a member of the Principal Financial Group.