Straightforward Guide to 529 College Saving Plans - Root Financial

Have you seen the cost of college recently? It’s insanely expensive.

Thankfully there are ways to help plan for this cost. One such way is through funding a 529 college savings plan.

Over the years I’ve talked to a lot of people about funding their children or grandchildren’s college. I’ve found that most people have heard of a 529 plan, but few actually know all the 529 plan rules or how to most effectively use them.

This article will give you an overview of everything you need to know to make an informed decision about how a 529 plan can help you.

What is a 529 Plan?

Let’s start with the obvious question – what is a 529 plan?

A 529 Plan is an account that you use to save for college expenses. There are tax benefits to using a 529 plan assuming you use the funds for qualified educational expenses at an eligible educational institution.

Each state sponsors at least one 529 plan . California, for example, sponsors the ScholarShare 529 Plan.

You do not have to use the 529 plan that your state offers, but doing so may provide certain tax benefits (more on that below).

Now let’s break this down further:

First, what is a qualified educational expense? Here’s a list of what’s considered qualified:

  • Tuition
  • Room & Board (only up to what school housing would cost)
  • Books
  • School supplies

And then here’s a list of what’s NOT considered a qualified expense:

  • Room & Board (in excess of what school housing would cost)
  • Sports or other club dues
  • Repayment of student loans
  • Transportation and traveling costs
  • These lists aren’t comprehensive, but they cover a lot of the common expenses students have.

Next, what is an eligible institution? The IRS defines it as “any college, university, trade school, or other post secondary educational institution eligible to participate in a student aid program run by the U.S. Department of Education.

To make it simple, if you want to know if a certain school made the list then here’s a link that will show you. There are over 6,600 schools on the list and the list is on an Excel spreadsheet. So get ready to bust out the Ctrl F function and start searching.

How does a 529 Plan Work?

You can use any type of savings account or investment account to save for college. So why would you use a 529 plan instead of the other options?

Tax benefits

The main purpose of a 529 plan is to provide a tax-incentivized way to save for college. So let’s start by breaking down the three (potential) tax benefits:

#1 Tax deduction on the contribution

You won’t ever get a deduction on your federal taxes for making a contribution to a 529 plan. Certain states, however, do offer income tax deductions.

I live in California and California does not offer any deductions for making 529 plan contributions.

But other states, like Oregon, offer a state income tax deduction if you are a resident of Oregon and you use Oregon’s state-sponsored 529 plan.

Then other states, like Arizona, offer state income tax deductions for contributing to any state’s 529 plan.

If you want to see if your state offers tax deductions for making 529 plan contributions then here’s a helpful chart that will show you: 529 State Tax Incentive Map.

Even if you’re a resident of a state like California, keep this in mind – if you’re a California resident but have parents who live in a state like Oregon then that creates some planning opportunities.

Assuming your parents want to help fund your kids (their grandkids) college, then instead of contributing money to an account you opened for your kids in California, they can open their own Oregon 529 plan and make contributions there. You can have more than one 529 plan for each beneficiary.

This would allow grandparents to get a tax deduction while saving for their grandkids college even if the grandkids live in a state where 529 plans don’t receive tax deductions.

Also, just because you contribute to one state’s 529 plan doesn’t mean you have to spend the funds for college in that state.

#2 Tax Free Growth

This one is pretty straightforward.

When you save money in a savings account or a taxable investment account you will receive interest and dividends.

All of these are taxable in the year they are realized.

With a 529 plan you wouldn’t pay taxes on either of these while the money is inside of the account. This applies to both federal taxes and state taxes.

#3 Tax Free Withdrawals

Probably the biggest benefit of 529 plans is the tax-free nature of the withdrawals you take from your account.

Assuming you use the funds for qualified educational expenses, any money you pull out of your 529 plan is tax-free.

Let’s look at an example:

Assume you open a 529 plan for your child as soon as they’re born and you add $250/month to the 529 plan for the next 18 years. Let’s also assume that the funds you invest in grow by 8% per year.

Over those 18 years you would have put a combined $54,000 into your account.

The account value though would be $112,350. That’s $54,000 of contributions and $58,350 of growth.

If it was in a regular taxable account, that $58,350 of growth would be taxable once you liquidated the account and use the proceeds to fund college. But if you’re using a 529 plan and you pull the money out to be used on qualified educational expenses then this isn’t taxable.

This has the potential to save you several thousand dollars in taxes. If you were in a marginal federal/state tax bracket of 30%, for example, then you would save $17,505 in taxes ($58,350 x 30%).

What Can You Invest In?

Once people understand the tax benefits of a 529 plan, their next question is “What can I invest in?”

This is where it depends on what state’s 529 plan you’re using.

You don’t have free rein to invest in whatever stock, bond, or mutual fund you would like. Each state will have a list of investment options that you can choose form.

If you have a 401(k) plan through your employer then you know how this works. You are offered a number of investment options and you choose the funds you want as well as what percentage you want invested into it.

This is where it becomes important to select the right plan. You want to make sure that your plan offers robust options at a fair price.

How Much Can You Contribute?

There are no limits for how much you can contribute to a 529 plan each year. There are, however, maximum aggregate limits that vary depending on the plan you use.

With California’s Scholarshare plan, for example, you can’t make additional contributions to your 529 plan once the account value has reached $529,000. If you have that amount in your account then the assets can continue to grow above $529,000, but you cannot contribute anymore to the account.

Even though there are no annual contribution limits, you do need to be mindful of potential gift taxes when making 529 plan contributions. A contribution to a 529 plan is considered a gift.

For 2019 you can gift up to $15,000/year tax-free. If you contribute above that then you would need to file Form 709 to report a taxable gift.

One of the unique benefits of 529 plans though is you can choose to “front load” five years of gifts into a single year. Meaning you can make a one-time gift of up to $75,000 into a 529 plan without having to pay taxes on the gift.

This can be an effective estate planning provision if grandparents or parents are trying to get assets out of their estate into an account where they still have control over the funds.

For most people though, contribution limits to 529 plans are almost inconsequential because of how high they are.

What if You Don’t Use the Funds for College?

The biggest hang up people typically have when it comes to using a 529 plan is the lack of flexibility they have with the funds. This is true to an extent, but it’s important to understand what your options are if your child or grandchild doesn’t end up using the funds.

Let’s start of by assuming that your child or grandchild skips out on college altogether and you take a full withdrawal of the funds.

In this case you would get all of the money you contributed back tax-free and penalty-free. But you would pay taxes and a 10% penalty on the growth that you pulled out of the account.

Keep in mind you got tax-free growth while the money was in the 529 plan, so the taxes are mostly just washing out any tax benefit you would have received on the front end. It’s really the 10% penalty that hurts you in this case.

But now let’s look at some situations that would be treated differently –


If your child receives a scholarship then you won’t be penalized for that.

If you don’t end up needed all of your 529 plan assets because of this scholarship then you are able to withdraw the amount of the scholarship from the 529 plan without paying a penalty. You would still pay taxes on this amount, but the 10% penalty is waived.

Death or Disability

In the unfortunately event that a child passes away or is disabled then the 10% penalty is also waived.

Taxes would still apply to any investment growth, but you would not have to pay the 10% penalty when withdrawing the account.

Change the Beneficiary

There is a simple way to avoid paying taxes or penalties on your 529 plan if the child you opened it for doesn’t use the funds for college.

You just transfer ownership to another family member.

It doesn’t even have to be an immediate family member. A list of eligible family members include, but isn’t limited to:

  • Parents
  • Siblings
  • Children (including stepchildren and adopted children)
  • Nephews and nieces
  • Aunts or uncles
  • First cousins

When people are deliberating about opening a 529 plan and they have (or plan to have) multiple children, I often encourage them to go ahead and start funding a 529 plan for the oldest child.

In the event that the oldest child doesn’t use the account, then you can easily transfer the account to the next child without any taxes or penalty.

What About ESAs?

In the past people used to decide between funding an Education Savings Account (ESA) or a 529 plan to save for college. The recent change to tax law changed the law in a way that made ESAs almost, but not entirely, useless when compared to a 529 plan.

So even though ESAs still has tax benefits, 529 plans contain almost all of these benefits and more.

Is a 529 Plan Right For Me?

At the end of the day I wouldn’t recommend that people prioritize college savings over their own retirement savings.

But assuming you are in a position to save for kid’s college, a 529 plan is a fantastic option to do so.

What do you think? How are you saving for college for your children or grandchildren?