529 Plans: Unsung Heroes of Financial Planning

If you’ve thought that 529 Plans, also known as qualified tuition programs, are relevant only to parents and prospective college students, you are not alone. But you’ve been mistaken. The 529 Plan is an unsung hero of financial planning that deserves some attention and celebration.

Qualified tuition programs, in the form of pre-paid tuition plans and college savings plans (the latter being more common and the one we’ll mainly be referring to here), were first created by various states in the 1980s and 1990s as tools to encourage saving and investing for rapidly rising college expenses, essentially by allowing invested money to grow tax-free.

In 1996, Congress codified the concept in section 529 of the Internal Revenue Code, hence the current name. The basic structure of a 529 Plan consists of an “owner,” or creator/donor, who opens and funds an account with a state-sponsored administrator for the benefit of the account’s “beneficiary,” who will use the funds sometime in the future to pay for education expenses.

Even in their earlier incarnations, 529 Plans could achieve several important goals: 1) tax-free growth (once invested in a 529 Plan, money grows tax-free); 2) tax-free withdrawal (no income tax owed by the plan’s beneficiary when the invested funds are withdrawn for their intended purpose); and 3) a method of giving by family members that can be earmarked for higher education.

In the decades since their creation, revisions to the rules governing 529 Plans have significantly increased their utility and flexibility, turning 529 Plans into a savings and planning vehicle that can be useful to just about everyone.

Keep in mind that in the realm of 529 Plans, there are significant differences between states. For example, there may be additional state income tax incentives or limitations on qualified expenses as they relate to state income tax. But in terms of federal income taxes and the rules mentioned in this article, all states’ 529 Plans work the same. 

To begin with, 529 Plans can be created by any adult or trust for the benefit of any U.S. citizen—not just family members—including for oneself. There are no income eligibility limits, and the contribution limits per account are generally high, typically $500,000 (with the opportunity for the accounts to grow well above the contribution limits). Contributions are usually made over time using the annual gift-tax exclusion (currently $19K per year), but an owner can choose to contribute more in a given year and file a gift tax return. There is also no limit to the number of 529 Plan accounts an individual can have, as either an owner or a beneficiary.

Moreover, friends and family do not necessarily need to create a new account in order to give to a 529 Plan. They can instead give directly to an existing account. While each state’s 529 program is different, there are no residency requirements for establishing an account, and the funds may be used at out-of-state institutions that accept federal financial aid (and even for some study abroad programs).

More significant from a financial planning perspective, 529 Plans enjoy a “super-funding” rule, which allows an individual or married couple to use five years’ worth of annual gift tax exemptions in a single contribution. In other words, an individual can contribute $95,000 at once per 529 account (married couples can contribute $190,000). Note, however, that any subsequent contributions in the following four years to the same beneficiary would eat into the donor’s lifetime gift tax exemption.

Donors can also intentionally “overfund” 529 Plans, meaning they can invest far more than the anticipated education expenses of the named beneficiary. Such funding can be done through a lump sum gift and/or periodic giving and can achieve two noteworthy objectives: 1) it can effectively lower the size of one’s taxable estate while 2) it also helps cover the cost of education for one or more family members, even multiple generations of family members, thanks to the flexible transferability of 529 Plans discussed below.

The beneficiary of a 529 Plan account can be changed at any time, without tax ramifications, to any member of the beneficiary’s family (sibling, step-sibling, parent, niece/nephew, aunt/uncle, cousin, and others). What’s more, there is no limit on the number of times the beneficiary can be changed. If, say, a grandfather overfunds a 529 Plan beyond his beneficiary granddaughter’s college expenses, once the granddaughter graduates, he can change the beneficiary to another family member.

Alternatively, 529 Plan funds can be rolled over into ABLE accounts up to the annual contribution limit ($19,000 in 2025) if the named beneficiary is disabled. Or up to $35,000 can be rolled over from a 529 Plan into a Roth IRA (so long as the 529 Plan has been open for 15 years, the 529 beneficiary and Roth IRA owner are the same person, and the beneficiary has earned income in the year of the rollover). 

The flexibility and utility of 529 Plans have also increased thanks to a legislative definitional expansion of what constitutes a “qualified education expense.” 529 Plan funds can now be used to pay for tuition at private elementary or secondary schools or at trade and vocational schools, in addition to traditional colleges and universities. They can also be used for many qualified non-tuition education-related expenses such as computer technology or equipment, books, room and board at eligible institutions, equipment for registered apprenticeship programs, or even payment of up to $10,000 toward principal or interest on qualified education loans for the Plan’s beneficiary and/or her siblings.

Notably, the 10% penalty for non-qualified distributions is waived under several circumstances, including if the account’s beneficiary dies, becomes disabled, receives a tax-free scholarship (up to applicable amounts), receives veterans’ education assistance or employer educational assistance (up to applicable amounts), or attends a U.S. military academy.

In addition to investing in 529 Plans to benefit close friends or family members, adults can open a 529 account to benefit themselves.  This can help the person who wants to change careers but needs to go back to school, or who wants an advanced degree in the same field. It can also help provide for an enriched retirement experience for those who would enjoy taking college courses in their increased free time.

Are there any downsides to 529 Plans?  Like any savings plan or investment vehicle, 529 Plans are not perfect.

One limitation is they do not offer full control over your investments. Similar to most 401(k) plans, the owner of a 529 Plan can usually choose among a variety of investment portfolios or index funds but cannot invest in individual stocks, bonds, or ETFs; and the owner is only allowed to make changes to the investments twice a year.

There is also no guaranteed rate of return with 529 Plans, and they are not free to open or manage. The fees and expenses associated with the plan’s administration are generally modest, however.

From a financial aid perspective, 529 Plans that are owned by a parent of the student are treated as parental assets (with 5.54% of the account’s value counting toward the family’s ability to pay). But 529 plans owned by a grandparent or other friend or relative are not reported on the FAFSA and thus do not affect a student’s eligibility for need-based financial aid. Given the numerous benefits and uses of 529 Plans, it’s fairly easy to argue that the pros outweigh the cons.

If someone in your life, including yourself, can benefit from tax-free investment in education, talk to your financial advisor and research which state offers you the best 529 Plan.