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How Do 529 College Savings Plans Work?

The cost of college tuition has been on the rise in recent years and shows no signs of slowing. For the 2019-2020 school year, the average cost of tuition ranged from $10,116 for public in-state schools to a whopping $36,801 for private colleges and universities, according to U.S. News. And while loans for both students and their parents are available, many families would rather avoid saddling their children with $40,000 or more in debt as soon as they graduate.

One way to help offset student loan debt is to start saving early for college tuition. The earlier families begin saving, the more potential those savings have to grow. And a popular option many families explore for growing those college savings is what’s known as a 529 plan.

529 plans are typically sponsored by states or state agencies. They’re named after Section 529 of the Internal Revenue Code, which authorizes tax-free status for qualified tuition programs. The main appeal of 529 plans is that earnings accumulate on a tax-deferred basis, and distributions aren’t taxed federally when they’re used for qualified higher education expenses.*

But how exactly do they work? Let’s take a look.

529 Plans: The Options

There are actually two types of 529 plans: savings plans and pre-paid tuition plans.

529 savings plans are much more common and flexible, generally allowing funds to be used at any college or university and for all qualified expenses, including tuition, room & board and books. 529 savings plans work similarly to retirement plans, in that contributions made can be invested in select options designed to help grow the money over time.** Investment options often include mutual funds, money market funds, and age-based portfolios that shift toward more conservative investments as the student gets closer to college age. In California, this is the only type of state-sponsored 529 plan available.

Some other states offer 529 pre-paid tuition plans either in place of or in addition to 529 savings plans. Pre-paid tuition plans allow families to essentially purchase credits toward tuition at participating colleges and universities. By purchasing these credits early, they can lock in the price of tuition. But 529 pre-paid tuition plans tend to be more restrictive, only allowing the funds to be used for certain costs at a limited number schools.

Tax Benefits

Earnings in 529 plans are not subject to federal tax. In most cases, earnings are also tax-free at the state level, as long as withdrawals are used for eligible college expenses. However, if you withdraw money from a 529 plan for something other than an eligible college expense (say, for example, to buy your college student a car), regular income tax and an additional 10% federal tax penalty generally apply on earnings. In California, there may be some exceptions to this if the withdrawals are used for tuition at a public, private or religious elementary, middle or high school.*

Setting Up a 529 College Savings Plan

Once you choose a 529 savings plan, you’ll generally need to fill out an application to open an account, and name a beneficiary. Each plan can only have one beneficiary, but that beneficiary can be changed to another eligible family member in the future, if needed. So, for example, if your oldest child decides not to go to college, you can transfer the account to a younger child, or even a grandchild, niece or nephew.

When you first open the account, you may be required to make a minimum contribution. After that, most plans let you contribute as often as you like. This gives you the flexibility to tailor contributions based on your family’s unique needs and budget. There’s also usually an option to set up automatic monthly contributions, allowing you to put your college savings plan on auto pilot.

Any time a new contribution is made, a different investment may be selected for that amount. However, under federal law, existing plan investments can only be exchanged for new investments twice per year.

To learn more about 529 college savings plans in California, visit ScholarShare529.com or talk with a financial professional.

 
*Consult a qualified tax professional for more information.
**Investments in 529 savings plans are not guaranteed and are subject to market risk that may increase or decrease in value. More information about 529 plans can be found in the issuer’s official statement or plan disclosure document which should be read carefully prior to investing.

***The information in this blog post is a compilation of a number of third-party resources.