Saving for a child's education is one of the most hopeful investments you can make, but navigating the rules around these accounts can sometimes feel overwhelming. You want to ensure that the money you set aside today works as hard as possible for your family's future. We're here to break down the jargon so you can build a roadmap that feels right for you and your loved ones.
The two main types of college savings strategies
While 529 plans get their name from the federal tax code, they are actually run by individual states. This means the rules, fees, and investment options can look different depending on where you look.
The good news is that you aren't forced to enroll in your specific state's plan. You can look across state lines to find the best fit for your goals.
Generally, you will encounter two specific types of plans.
| Feature | Prepaid tuition plans | College savings plans |
|---|---|---|
| What it does | Aims to lock in tuition rates at today's cost | Invests after-tax money for potential tax-free growth |
| Availability | Offered in about 18 states, often with strict residency requirements | Available in all 50 states, no residency requirements |
| Coverage | Often limited strictly to fees and tuition at in-state schools | Covers tuition, room, board, and more at most accredited schools |
| Risk level | Lower risk, but fewer options if the student goes out of state | Subject to market volatility, similar to a Roth IRA |
Prepaid tuition plans
Also known as a prepaid 529 plan, this option allows you to pay a set price now that is lower than what tuition might cost when your child is ready to attend college.
However, these plans are becoming less common. They are only offered in about 18 states, and many have strict residency requirements. This means you usually must live in the state to participate in their specific prepaid plan.
Furthermore, qualified expenses are often limited strictly to fees and tuition. This leaves you to cover things like room and board out of pocket.
College savings plans
This is the more common route. A college savings plan lets you invest your money after-tax, which works very much like a Roth IRA.
While the account value may fluctuate with the market, your investments have the potential to grow tax-free. When you withdraw the money for qualified education expenses, you don't pay any taxes on the growth.
Another benefit of this route is that many states offer tax breaks on the contributions you make each year. It's also a great way to get the village involved, as friends and family members can contribute to your child's 529 plan, subject to some dollar limits.
What costs does a 529 plan cover?
The tax benefits of a 529 education savings plan are powerful. You get potential tax-free earnings growth and tax-free withdrawals, provided the money is used for specific educational expenses.
This covers the basics like tuition and books. Generally, you can also use the proceeds to cover room and board, though there are some restrictions for things like off-campus housing.
One important nuance is health insurance. Student health insurance is usually not covered unless the college charges it as part of a comprehensive tuition fee or identifies it as "required for enrollment or attendance" at the institution.
Your 529 assets can also stretch beyond standard four-year university costs. You can use these funds for:
- K-12 Education: You can use up to $10,000 per year to pay for K-12 private school tuition.
- Advanced Degrees: Funds can be applied to graduate programs.
- Debt Repayment: You can use funds to pay student loans, with a lifetime cap of $10,000 per borrower.
Choosing the right path for your family
Deciding between the two types of plans often comes down to your tolerance for risk and your desire for control.
If you use a prepaid tuition plan, you might gain peace of mind if you are confident the student will attend an in-state university. Most qualified expenses at any in-state facility will likely be covered. If your student chooses an out-of-state school, the plan will pay you a set amount based on your contributions. You or the student will have to make up the difference if that school costs more.
With a typical 529 college savings plan, you have more control. You choose how much to contribute and when. You also choose where to invest, though selection is usually limited.
The trade-off is risk. Your student's tuition isn't guaranteed to be pre-paid, and your investments are subject to market volatility just like non-education accounts.
Are you limited to your state's plan?
No, you aren't. Families can invest in the college savings plan of any state. Because investment offerings and fees vary, you might find that another state offers a plan with lower fees or different potential returns.
However, there are two things to keep in mind before looking elsewhere. First, it is usually better to invest through a state program rather than directly through a fund manager, even if the state plan is administered by a big name like Vanguard or T. Rowe Price.
Second, many states offer tax breaks specifically to their own residents. If you invest out of state, make sure you understand if you're giving up a local tax advantage.
What if we don't need the money for college?
This is a common worry. What if your child decides not to go to college, or earns a full scholarship? The good news is that the money isn't lost.
Your first option is portability. You can transfer the money to another child or family member with no adverse tax consequences.
Thanks to the SECURE 2.0 Act, you now have another powerful option. You can roll over unused 529 funds into a Roth IRA for the beneficiary. There is a lifetime limit of $35,000 for these transfers. The rollover is penalty-free and tax-free, subject to certain conditions. This is a fantastic way to jumpstart your child's retirement savings if they don't need the money for school.
If your child gets a scholarship, you can withdraw the amount of the scholarship annually and use it for non-education purposes. You will have to pay taxes on the earnings, but you won't face additional penalties.
If you simply want to withdraw the money for a non-education purpose, you will pay income taxes and a 10% penalty on the earnings portion of the withdrawal. However, that 10% penalty on earnings is waived in specific situations, including:
- The beneficiary receives a tax-free scholarship.
- The beneficiary attends a U.S. Military Academy.
- The beneficiary dies or becomes disabled.
Facet is not an attorney and does not provide tax or legal advice. This content reflects tax rules and regulatory limits as of 2021 and may no longer be current. Consult a tax professional regarding your specific situation.
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