Do 529 Plans Earn Interest or Investment Returns?

A 529 plan is a tax-advantaged investment account specifically designed to help families save for education expenses. It serves as a dedicated savings vehicle for future educational costs, ranging from K-12 tuition to college and even some apprenticeship programs. The value within a 529 plan grows over time, not through traditional interest accumulation, but through investment returns generated by underlying assets.

How 529 Plans Generate Returns

529 plans generate returns through investments in various underlying assets, rather than traditional interest like a savings account. These plans offer a range of investment options, typically managed portfolios that invest in mutual funds, exchange-traded funds (ETFs), or a combination of both.

Common investment options include age-based portfolios, which automatically adjust their asset allocation to become more conservative as the beneficiary approaches college age. For instance, a portfolio for a young child might be heavily invested in stocks for growth potential, gradually shifting to bonds and cash as college nears. Other options may include static portfolios, where the asset allocation remains fixed unless the account owner makes changes, or individual fund portfolios allowing selection of specific mutual funds or ETFs. The performance of these investments determines the overall return of the 529 plan.

Tax Treatment of Accumulated Earnings

Earnings within a 529 plan grow tax-deferred, meaning federal income tax is not owed on the investment gains as long as the funds remain in the account. This allows earnings to compound without annual taxation. When withdrawals are made for qualified education expenses, the earnings portion is entirely federal income tax-free.

Qualified education expenses include tuition, fees, books, supplies, and equipment for eligible educational institutions. Room and board also qualify if the student is enrolled at least half-time. Additionally, up to $10,000 annually per beneficiary can be used for K-12 tuition at public, private, or religious schools, and a lifetime limit of $10,000 per individual applies to student loan repayments. State tax treatment of 529 plans can vary, with some states offering additional benefits such as deductions or credits for contributions, while others may not.

Factors Influencing Investment Growth

Investment choices significantly impact potential growth and risk. Aggressive portfolios with higher stock allocations aim for greater returns but also carry more volatility. Conversely, conservative portfolios, typically holding more bonds and cash, aim for capital preservation with lower, more stable returns.

Fees associated with 529 plans can also reduce overall returns. These may include administrative fees, investment management fees, and other charges, which vary between plans. Account owners should review a plan’s fee structure, as even small differences in expense ratios can notably impact long-term growth. Since 529 plans are investment accounts, their performance is subject to market fluctuations. There are no guaranteed returns, and the value of the account can rise or fall based on the broader market performance.

Making Withdrawals

Accessing funds from a 529 plan involves a request process. Withdrawals can be sent directly to the educational institution, the account owner, or the beneficiary. Withdrawals and expenses must occur within the same calendar year to ensure proper tax reporting.

Withdrawals for qualified education expenses are federal income tax-free. However, if funds are withdrawn for non-qualified expenses, the earnings portion of the withdrawal becomes subject to the account owner’s ordinary federal income tax rate. A 10% federal penalty tax is also applied to the earnings portion of non-qualified withdrawals. State tax implications for non-qualified withdrawals may also apply, potentially including the recapture of any state tax benefits previously received.

The 10% federal penalty may be waived in specific circumstances, such as the beneficiary’s death or disability, or if the beneficiary receives a tax-free scholarship. Unused 529 funds can be rolled over to another 529 plan for a different eligible family member without penalty or tax. As of 2024, unused funds can also be rolled over to a Roth IRA for the beneficiary, up to a lifetime limit of $35,000, provided the 529 account has been open for at least 15 years and other conditions are met.