529 Account: What It Is and Top Rules to Know - NerdWallet (2024)

The price of higher education isn't cheap, which means it's a good idea to start saving while kids are learning their ABCs — not while they're studying for their SATs.

For most people, the choice of college savings vehicle is easy: 529 plans offer some great incentives for saving.

What is a 529 plan?

A 529 plan is a savings plan that can provide tax-free investment growth and withdrawals for qualified education expenses. 529 plans have high contribution limits, which are generally intended to be enough to cover the cost of college.

Parents, guardians and anyone else who wants to help fund college for a loved one can start saving in a 529 account to take advantage of the tax savings, the compounded returns and — in some states — a tax deduction on contributions.

To help those who won't end up using the funds, a portion of a 529 can be rolled over to a Roth IRA in the beneficiary's name, tax- and penalty-free. The limit is $35,000, as long as the 529 account has been open for at least 15 years. Keep in mind that $35,000 is a lifetime capand the rollovers are subject to the Roth IRA's annual contribution limits, which means you'll need to roll in chunks.

That's just one of the rules of 529 plans. There are more, particularly around distributions. Here are the main ones you need to know.

How does a 529 plan work?

1. 529 plans are state-sponsored, but you can pick a plan from any state

Most states offer at least one 529 plan. You don’t have to invest in your own state’s plan, but many states offer residents a state tax deduction for doing so. (There is no federal tax deduction for 529 contributions.) If your state doesn’t offer any tax benefits, shop around to find the best plan for you — NerdWallet has a list of all state 529 plans.

The state that sponsors your plan doesn’t have any role in where the child can go to school; students can use the money to attend a qualified school in any state.

The exception to that is a specific kind of 529 plan called a prepaid plan, which, as the name implies, allows you to prepay tuition at an in-state, public college, locking in the cost in today’s dollars and at current tuition rates. Only a few states offer prepaid 529 plans.

2. The account holder maintains ownership of the funds

Unlike other college savings vehicles, such as custodial accounts, 529 plans allow the funds to remain under the account owner’s control, meaning you can withdraw the money at any time (though taxes and penalties may apply; more on this below). The beneficiary does not have control over the money in the account, even when they reach the age of majority, which is between the ages of 18 and 21, depending on the state.

3. Qualified distribution rules are strict

A 529 is specifically for qualified education expenses, though that category extends beyond tuition; it also includes fees, room and board, textbooks, computers and “peripheral equipment” (such as a printer). A 529 plan can also be used to pay for private or religious elementary, middle and high school tuition.

Withdrawals made for purposes outside the rules come with a price: Earnings withdrawn for nonqualified expenses are subject to a 10% penalty and ordinary income taxes. There is no penalty on the principal (the amount contributed). If you take a withdrawal from a 529, you'll need to file IRS Form 1099-Q.

Account owners can change the beneficiary on the account at any time. If, for example, the child decides to take a different path, you can change the account beneficiary so that the money will go toward paying for a sibling's or other family member's education instead. Or, you can roll some of the account beneficiary's money into a Roth IRA for them, as mentioned above.

4. Contribution limits are high

States generally set the contribution limit for their 529 accounts, rather than the IRS setting the limit, as is the case with retirement accounts. The IRS only stipulates that contributions can't be more than the amount required to pay for qualified education expenses. Note that there are no eligibility requirements or limits based on income.

For many families, 529 plans will be the obvious choice for college savings. Most plans offer age-based investment options that will automatically rebalance, taking more risk as a child is young and less as they approach college age. You can open a 529 plan directly through your state’s plan website or through some online brokers.