What Is a 529 College Savings Plan? Learn About the Great Tax Benefits

This savings plan can help make college more affordable.

The 529 plan is a type of account that — for many Americans — is the best way to save for college. The benefits of 529 plans can provide parents with some respite from the tremendous costs of helping their children pay for their college education and avoid any taxes they might owe in the process. Keep reading to find out what you need to know about college savings plans to see if a 529 plan is right for you.

What Is a 529 College Savings Plan?

A 529 plan is a savings plan designed to help make it more affordable to save money for future education expenses. There are actually two types of 529 plans: prepaid tuition plans and college savings plans.

Eleven states offer a 529 prepaid tuition plan wherein you can pay tuition now — locking in the present rate — and receive credits for future semesters at qualifying institutions.

The 529 college savings plan, however, is the more popular option and is offered in some form by all 50 states. In this case, you make contributions to an account that gives you certain tax advantages and allow your investments to grow over time before ultimately pulling them out when you have qualifying education expenses.

How Does a 529 Savings Plan Work?

The 529 college savings plan is very similar to a Roth IRA in its structure in that you put after-tax income into the plan but won’t have to pay any federal income taxes on future qualified withdrawals — allowing it to grow tax-free until you need it. The qualified withdrawals, however, come in the form of a variety of education expenses for the account’s beneficiaries, which can include tuition, room and board, computers, books and — as of the most recent tax bill — some tuition for K-12 private schools.

One benefit for a 529 college savings plan over a Roth IRA is that there are no limitations on how much you can put into it in a given year, whereas a Roth IRA is capped at $6,000 annually. That means that you can find a tax-advantage home for a much larger amount of money using a 529 plan. The one caveat, though, would be that you could potentially owe gift taxes if you exceed $15,000 into a single child’s 529 plan in a single year, or $5.6 million over the course of their lifetime.

Help Out: 5 Reasons a 529 College Savings Plan Is the Best Baby Shower Gift

What Else Do I Need to Know About Setting Up a 529 College Fund?

Even though the nuts and bolts of the different college savings plans are all relatively similar, it is worth noting that each state runs its own and differences between them could exist. What’s more, you might be able to shop around for better fee structures — and therefore hang on to more of your money — as some plans are open to people who live out of state. That said, some plans will also offer tax benefits or matching funds for investing in-state.

You should also know that — much like your IRA — raiding it for purposes other than what it’s intended for will cost you. If you make a withdrawal for something other than qualified education expenses, you’ll owe taxes on that money just like normal income plus an additional 10 percent tax penalty. If your circumstances change and you won’t need the 529 for its original beneficiary, you can change the beneficiary once a year. So, for example, if one child doesn’t go to college, you can move it to another or just wait for the first grandchild.

Anyone can set up a 529 plan, you’ll just need your own information and that of the account’s beneficiary. One beneficiary can have multiple accounts set up for them, and one person can also own several accounts, so there’s flexibility that allows for parents, grandparents, aunts and uncles to all get in on the action if they’re so inclined.

Click through to read more about parents dropping out of 529 college savings plans.

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