529 Plans: The Complete Guide to Saving for College

529 Plans The Complete Guide to Saving for College
Elliott Appel, CFP®, CLU®, RLP®

Elliott Appel, CFP®, CLU®, RLP®

Welcome! I'm the founder of Kindness Financial Planning, LLC, a fee-only, fiduciary advisor located in Madison, WI working virtually with widows, caregivers, and people affected by major health events across the United States. When I'm not helping people live their ideal life, I'm often cooking for my wife, playing tennis, or hiking.

Last Updated on January 9, 2023


College is expensive. 

The average public, out-of-state tuition is $22,953 for the 2022-2023 school year. 

If tuition rates increase at a 3% rate per year over the next 18 years, the average public, out-of-state tuition could cost about $39,076

The total cost over four years would be $163,479. 

For most people, paying out of pocket isn’t feasible, which is why a 529 plan is an excellent way to start saving for college today. 

Whether you are a parent, grandparent, or other family member, setting up a 529 plan for a loved one could mean the difference between a lifetime of student loan payments and financial flexibility. 

Let’s talk about how to save for college. I’ll cover the following:

  • What is a 529 plan?
  • How much you can contribute to a 529 plan
  • How does a 529 plan impact financial aid eligibility?
  • How to take withdrawals from a 529 plan
  • What if the child doesn’t go to college?
  • How to choose a 529 plan
  • How to choose the investments in a 529 plan

What Is A 529 Plan?

A 529 plan is a tax-advantaged account used for saving, investing, and paying for qualified education expenses. They are legally known as “qualified tuition plans.”

Many people think about them being used to pay for college, but they can also be used for K-12 tuition and student loan repayment. 

There are two types of 529 plans: prepaid tuition plans and education savings plans. 

Prepaid tuition plans allow people to purchase units or credits at colleges for future tuition. People choose these plans to lock in the cost of college today. By purchasing units, it doesn’t matter how much tuition increases because you have already locked in the cost of college. Some plans are guaranteed by state governments, but others are not. If the plan sponsor has financial issues, you may lose some or all of the money in the plan. It’s one risk to be aware of. 

I’m not going to talk about prepaid tuition plans. 

Instead, I’m going to focus on education savings plans, which allow people to open investment accounts to save and invest for future qualified education expenses. They usually provide more flexibility in the ways you can invest and use the money for college. 

How Much You Can Contribute to a 529 Plan

Most plans allow you to contribute somewhere between $235,000 and $529,000; however, you need to be aware of gifting limits. 

The annual gift tax exclusion amount for 2023 is $17,000 per individual. This means that any person can give up to $17,000 per year to as many individuals as they want without needing to file a gift tax return.

For example, if there are two married grandparents who have four grandchildren, they could give $34,000 to each grandchild ($17,000 per grandparent) for a total of up to $136,000. 

Please keep in mind that the $17,000 is total gifting for the year. If you give cash or other gifts throughout the year, you’ll need to lower the contribution amount to stay within the gift tax exclusion amount.

It’s not the end of the world if you go above the gift tax exclusion amount. You’ll need to file a gift tax return using Form 709, but no taxes will likely be due.

The amount above the gift tax exclusion amount will count against your lifetime estate tax exemption amount and reduce the amount you can pass estate-tax free at death. In 2023, the lifetime estate tax exemption amount is $12.92 million per person, though this may be reduced in the future. 

Superfund a 529 Plan

Another method of contributing to a 529 plan is to “superfund” it. 

Superfunding is where you can make a contribution equal to 5 years’ worth of the gift tax exclusion amount and average it over 5 years. 

For example, since the 2023 gift tax exclusion amount is $17,000, you could make an $85,000 lump sum contribution in 2023 ($17,000 times 5 years), file a gift tax return using Form 709, and check the box that allows you to split it over the next 5 years. 

In this scenario, you will only be able to make additional gifts to the beneficiary without needing to file another gift tax return if the annual gift tax exclusion increases. For example, if the annual gift tax exclusion increased to $18,000 in 2024, then you could give $1,000 more in 2024.  If the annual gift tax exclusion amount does not increase, you would need to wait until the end of the five years to give more money. 

If you wanted to contribute $50,000, you would still prorate it over five years and file a gift tax return. For example, you would file Form 709, check the box, and allocate $10,000 per year. This would leave $7,000 per year for additional gifts. 

If a couple superfunds the 529 plan, two gift tax returns will need to be filed (one for each). 

Superfunding a 529 plan is particularly attractive for people who have large amounts of cash and are trying to jump start college savings for a family member. 

However, you need to be aware of state tax benefits (discussed later). You may be giving up state tax deductions if you superfund a 529 plan because certain states may only offer a state tax deduction on contributions up to a certain level, in which case it may be better to spread the contributions out over a number of years to maximize the deduction. 

How Does a 529 Plan Impact Financial Aid Eligibility? 

529 plans have little impact on financial aid eligibility.

If the 529 plan is owned by the parents of a dependent student, the 529 plan would be included as the parents’ assets on the Free Application for Federal Student Aid (FAFSA). 

The parents’ assets are one factor used to determine a child’s Student Aid Index (SAI); however those assets will only reduce aid by up to 5.64%. 

For example, if you saved $20,000 in a parent-owned 529 plan, aid will only be reduced by up to $1,080. 

Contrast this to student-owned assets. Student-owned assets reduce aid by up to 20%. The same $20,000 in the student’s name could reduce aid by up to $4,000. 

Grandparent-owned 529 plans are another strategic option, often used in coordination with a parent-owned 529 plan. 

If a grandparent or other relative owns a 529 plan, the 529 plan is not counted as an asset on the FAFSA, thereby not reducing aid; however, 529 plan withdrawals count as unearned income. Up to 50% of the unearned income can affect financial aid. For example, if you distributed $10,000 from a grandparent-owned 529 plan, that could reduce aid by up to $5,000. 

Many people use parent-owned 529 plans early in college and save withdrawals from grandparent-owned 529 plans until the second semester of sophomore year or later, assuming the child graduates in four years. 

By waiting until then, the withdrawals won’t negatively affect aid because the FAFSA looks at tax returns from two years’ prior to determine aid eligibility. 

Starting for the 2024-25 academic year, unearned income from grandparent-owned 529 plans should change and make grandparent-owned 529 plans even more attractive. The Consolidated Appropriations Act of 2021 changed certain rules around the FAFSA and financial aid eligibility, but the changes don’t take affect for a couple years. In 2024-25 academic year, grandparent-owned 529 plan distributions should not have any effect on financial aid eligibility, meaning distributions could be taken any time. 

Please keep in mind that grandparent-owned 529 plans are still factored into the CSS profile, which is used by some private colleges to award financial aid. 

In summary, grandparent-owned, or non-parent owned, 529 plans are attractive methods of saving for college that can have little impact on financial aid eligibility. Even parent-owned 529 plans have minimal impact on financial aid eligibility. 

How To Take Withdrawals From a 529 plan

You did a great job saving and investing in a 529 plan. Now what? 

How do you take withdrawals in a tax-efficient way? 

As long as withdrawals are for qualified education expenses, withdrawals are tax-free. That means you received years, and potentially decades, of tax-free growth followed by tax-free distributions. 

What is a qualified education expense? 

Qualified educational expenses include:

  • Tuition and fees
  • Room and board if enrolled at least half time
  • Textbooks 
  • Supplies, equipment, and other expenses needed to attend school 

What expenses don’t count?

  • Insurance
  • Transportation
  • Medical expenses

To take withdrawals in a tax-efficient way, you want to add up your qualified education expenses and take a withdrawal in the same year in which you paid for the qualified expenses. 

However, your qualified education expenses need to be reduced by Pell grants, tax-free scholarships, tuition discounts, and other tax-free educational assistance. Then, they need to be reduced by the costs used to claim the American Opportunity Tax Credit or Lifetime Learning Credit. 

Once you have subtracted tax-free educational assistance and the two education tax credits for which you may be eligible, that is the amount you can withdraw tax-free. 

What if you distribute more than your qualified education expenses? 

The earnings portion of the distribution is taxed as ordinary income and subject to a 10% penalty. The principal portion, or the amount you contributed, is not subject to tax or penalty. 

For example, if you distributed $5,000 more than your qualified education expenses and $4,000 was principal and $1,000 was earnings, only $1,000 would be subject to income tax and subject to a 10% tax penalty. If you were in the 22% tax bracket, your income taxes might increase by $220 and the penalty might be $100.  

What If The Child Doesn’t Go To College? 

There are a few options if your child or grandchild decides not to go to college:

  • Leave the funds in the 529 plan – they may go later in life
  • Use it for apprenticeships, K-12 education or other trade schools
  • Change the beneficiary to another family member (most allow you to change it once a year)
  • Distribute the funds, pay ordinary income tax, and a 10% penalty on the earnings
  • Change the beneficiary to you or your spouse and enroll in an educational program 
  • Pay off student loan debt (up to $10,000 per person, which is a lifetime limit)

Many of these options have complicated rules you don’t want to run afoul of. Before deciding on an option, thoroughly research it and/or talk with an expert. 

How to Choose A 529 Plan

Now that you know more about 529 plans, the next logical question is: how does a person choose a 529 plan? 

After all, there are over 50 different 529 plans. Nearly every state has a 529 plan available. 

Tax Deduction for Contributions to a State Plan

Although you can use any state’s 529 plan, I recommend you first determine if you receive a tax benefit for contributing to your own state plan

Some states, such as Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania, even offer tax deductions for contributions to any state’s 529 plan – not just their state plan. 

If you do receive a deduction for contributing to your own state plan, I’d start by researching that plan. For example, I live in Wisconsin now, and they offer a dollar-for-dollar reduction in state-taxable income up to $3,860 for contributions to the Wisconsin 529 College Savings Program in 2022. 

If someone was in the 5.3% marginal state income tax bracket, that is a tax savings of approximately $204.58. 

It’s not a significant amount of money, which means I may be better off forgoing the tax deduction and contribute to another state plan if the fees or investment options are better in another state plan compared to the potential tax deduction. 

In Washington state, where I am from, we don’t have an income tax, so no state tax benefit was available for contributions. This meant when I lived there, I could focus solely on fees, investment options, and other features and didn’t need to factor in any potential tax deductions. 

Even some states with income taxes, such as California, do not offer tax benefits for contributions to their state plan. Those residents can also focus on other factors to make their decision about which 529 plan to use. 

Fees

If you have determined your state does not offer a tax deduction, the tax deduction is not worth it, or you can contribute to another state plan and still receive a tax deduction, consider fees next. 

You would think fees would be similar across plans. You would be wrong. Very wrong. 

For example, there are broker-sold 529 plans with significant fees. Some include Class A Shares with upfront charges as high as 5.75%

Direct-sold plans are normally a better route. This is what I normally suggest to people looking for a 529 plan, but even among direct-sold plans, the fees can vary. 

For example, my529 plan, which is one 529 plan I like, has an administrative asset fee of between 0.110% and 0.140% depending on the investment options chosen plus the underlying fund expenses of 0.01% to 0.35%. The all in fee is 0.12% to 0.49%. 

In contrast, the Arkansas 529 plan has an asset-based fee of 0.53%, which includes the investment services fee, state administration fee, and plan management fee. They also have a $20 non-resident account fee. If you are a resident, they waive that fee. 

Although 0.53% isn’t necessarily a high fee, it’s more than four times more expensive than my529 plan’s cheapest option. 

If you invested $10,000 as a non-resident into the Arkansas 529 plan, the cost after 10 years would be $859, assuming a 5% annually compounded rate of return.  

If you invested $10,000 into the my529 plan, the cost after 10 years would be between $153.75 and $615.99, depending on the investment options selected and assuming a 5% annually compounded rate of return. Most of the static investment options, such as a Total US Stock Market or 60/40 Balanced option, or the target date funds are less than $190 after 10 years.  

Fees make a huge difference over time and are a meaningful consideration when choosing a 529 plan. 

Investment Options

The last consideration is the investment options. Some plans have great age-based options that adjust to a more conservative allocation over time with low cost funds. Others choose higher cost funds in their age-based options. 

Some plans allow you to custom pick an allocation. Others don’t. 

Find a 529 plan that has the types of investments you want in a plan. 

Other Considerations

There are other considerations, such as minimum contributions, performance, and oversight from the state and investment manager, but I find the availability of a tax deduction, fees, and investment options are some of the more important considerations. 

The other option in selecting a 529 plan is to skip everything I said above and look at one of the “top 529 plan” lists like Morningstar produces

Personally, I like Utah’s 529 plan, called my529 plan. It’s what I personally use for a family member. 

But, you should still understand why any plans on Morningstar’s Top 529 Plan List made it to the top of their list and whether it’s the top for you personally. 

How To Choose The Investments In A 529 Plan

Once you have selected a plan, how do you choose the investments in a 529 plan? 

There are three main options:

  1. Age-based or target-date
  2. Static options
  3. Customized options

An age-based or target-date fund is the simplest approach. It’s a decent option for those who want to “set it and forget it.” These age-based portfolios automatically get more conservative as the beneficiary ages. 

For example, if the beneficiary is 1 year old, the plan may be mostly in stocks and as they get older, the age-based fund will sell stocks to buy bonds and other more conservative investments. By the time they reach age 18, most of the plan may be in conservative investments. 

Please be aware that not every age-based option adjusts the same. One age-based option that has someone enrolling in 2040 may have 20% in stocks while another 2040 enrollment fund may have 0% in stocks at age 18. 

Static options are also a good option if you want to have more control of the allocation. An example of a static option could be an 80% stock and 20% bond portfolio that maintains that allocation indefinitely. What’s nice about static options is you get to choose when you want to go from 80% stocks to 60% stocks, or any other allocation. You don’t get to choose the underlying investment funds, but you get to control the overall allocation.

The customized option is the option that provides you with the most control. With customized options, you get to choose the underlying funds and the overall allocation. Although there is a limited number of investment funds to choose from, as opposed to any fund available in the investable universe, you can pick them in what proportion you want to own them.  

For most people, an age-based option is going to be the easiest and simplest option, but if you want to control the allocation or the funds, a static or customized option is often available.

If you go the static or customized investment option route, don’t forget to regularly review the allocation as your child ages! For most people, it should become more conservative the closer they get to using the funds. 

For example, there were plenty of people who chose non-age based options and when the Financial Crisis hit in 2009, they were positioned too aggressively and saw account values drop more than 50%. 

It’s not ideal to see the money you planned to use for college drop over 50% right as you need it.    

Final Thoughts – My Question for You

Saving for college is no easy task. Not only is it expensive, but there are many 529 plan options from which to choose. 

Whether you decide to Superfund a 529 plan or make regular contributions, it’s important to understand how it may impact financial aid, develop a plan to take withdrawals tax-free in the future, and be aware of the options if your child or grandchild does not go to college. 

From there, you should research which 529 plan may be best for you. You need to consider the potential tax deductions, fees, and investment options. 

Once you have a plan selected, you need to select an investment option. Age-based funds are great options for people who want to set it and forget it. Static or custom investment options allow for more control. Both have their advantages.

I’ll leave you with one question to act on. 

How will you save for college? 

Disclaimer: This article is for general information and educational purposes only and should not be considered investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change. Click for full disclaimer.

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