What Is a 529 Plan and How Does It Work?

A 529 plan is a tax-advantaged account designed to encourage saving for education costs. Authorized under Section 529 of the Internal Revenue Code, these state-sponsored plans allow individuals to set aside funds for a designated beneficiary. The account owner maintains control over the funds and investment decisions. The money grows with tax benefits and can be withdrawn tax-free for qualified educational expenses, making it a common tool for long-term funding.

Types of 529 Plans

There are two distinct categories of 529 plans. The most prevalent type is the Education Savings Plan, which functions like a Roth IRA or 401(k) for education. In these plans, contributions are invested in various portfolios, often composed of mutual funds and exchange-traded funds, and the account’s value fluctuates with market performance. This option offers the potential for significant growth but also carries investment risk.

The second category is the Prepaid Tuition Plan, which allows an account owner to purchase tuition credits at today’s prices for future use at eligible institutions. These plans are designed to lock in current tuition rates, providing a hedge against future tuition inflation. Prepaid plans are less common and are sponsored by individual states, often with residency requirements. Their value is tied directly to the cost of tuition at participating colleges rather than market returns.

Tax Advantages of 529 Plans

The tax benefits for 529 plans operate on both federal and state levels. Federally, while contributions are not deductible, investments grow on a tax-deferred basis. This means no federal income tax is due on earnings as long as the money remains in the plan. When funds are withdrawn for qualified education expenses, the withdrawals and all accumulated earnings are free from federal income tax.

State tax treatment varies considerably, with more than 30 states providing an income tax deduction or credit for contributions. To receive this benefit, the contributor must often use their home state’s plan. The specific amount that can be deducted or credited differs by state. Some states are “tax-neutral,” meaning they do not offer a state tax deduction for contributions but still provide tax-free growth and withdrawals for qualified expenses.

Contributions and Investment Growth

Anyone, including parents, grandparents, or friends, can open an account or contribute to an existing one. Contributions are considered completed gifts for tax purposes and are subject to the annual federal gift tax exclusion. For 2025, an individual can contribute up to $19,000 per beneficiary without incurring gift tax, and a married couple can jointly contribute up to $38,000.

A feature of 529 plans is the ability to make a lump-sum contribution through “superfunding.” This provision allows a contributor to make five years’ worth of gifts in a single year—up to $95,000 for an individual or $190,000 for a married couple in 2025—without triggering the gift tax. The contributor must file IRS Form 709 to make the five-year election. Money in an education savings plan is invested in portfolios that include age-based options or static portfolios with a fixed asset allocation.

Using Your 529 Plan Funds

The primary use for a 529 plan is for Qualified Higher Education Expenses (QHEE) at eligible postsecondary institutions. These expenses include tuition, mandatory fees, books, supplies, and required equipment. Room and board costs are also covered for students enrolled at least half-time, up to the school’s official cost of attendance allowance for housing.

Federal legislation has expanded the definition of qualified expenses. In addition to QHEE, funds can be used for:

• Tuition at public, private, or religious K-12 schools, up to $10,000 per beneficiary, per year.
• Fees, books, and supplies for participation in a registered apprenticeship program.
• Repayment of a beneficiary’s qualified student loans, up to a lifetime limit of $10,000.

Handling Non-Qualified Withdrawals and Rollovers

If funds are withdrawn for non-qualified expenses, the earnings portion of the withdrawal faces tax consequences. While contributions are returned tax-free, the earnings are subject to ordinary income tax plus a 10% federal penalty. State income taxes and potential penalties may also apply to the earnings portion of a non-qualified distribution.

The SECURE 2.0 Act of 2022 permits tax- and penalty-free rollovers from a 529 plan to a Roth IRA for the beneficiary. This is subject to several conditions: the 529 account must be at least 15 years old, and contributions from the last five years are ineligible. The rollover amount is subject to the beneficiary’s annual Roth IRA contribution limit and has a lifetime maximum of $35,000, offering an alternative for leftover funds.