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529 plans for education: How they work & what to look for

Father walking with son

For many parents, one pathway to helping their children succeed is through education; however, the price of college has seen consistent ticks upward. Today, the average cost of a four-year degree is more than $35,000. And while recent debt relief efforts have helped some students and graduates chip away at their loan balances, it can be hard to know what resources the future may hold.

Higher education costs can complicate your family budget, especially as you balance other financial obligations like bills and saving for retirement. A 529 plan is one tool that can help you plan for educational expenses over the long-term, but how does a 529 plan work, and is it right for you?

What is a 529 savings plan?

A 529 is a state-sponsored investment plan with tax advantages that can help you save money for educational costs. Savings in the plan grow tax-deferred, and as long as withdrawals pay for qualifying educational expenses, they're tax-free.

Traditionally, 529 plans went toward saving for higher education, but over the last few years, the program has expanded to include educational costs for K-12 and apprenticeship programs. For K-12 expenses, the IRS limits withdrawals to $10,000 per year.

How does a 529 plan work?

Each 529 account has an owner who controls the investments and selects a beneficiary. The beneficiary might be a parent, grandparent, student, close friend of the family or even the owner themselves.

There are two types of 529 plans: one is for educational savings, while the other is a prepaid tuition program. Every state sponsors at least one type of 529 plan, and some private colleges and universities offer prepaid tuition plans.

Educational savings plan

The educational savings program is typically the more popular of the two plans. With this arrangement, the account owner chooses the plan and contributes money to it, and then the funds are invested. Investment options are typically preset—usually mutual funds, exchange-traded funds or target date funds based on the child's age. Account owners choose from what's available when signing up.

Over time, the performance of these investments determines the total amount of money in the 529 plan. These investments may go up or down; consider your risk level and the amount of time left before your child goes to school when deciding how to invest the money.

One way to think about a 529 savings plan is as an investment for education, in the same way that a 401(k) plan is for retirement. As with some retirement plans, 529 savings plans can have tax advantages. Some states offer tax deductions for 529 contributions (usually up to a limit); both withdrawals for qualifying expenses and any growth from contributions are also tax-free.

Prepaid tuition plan

A prepaid tuition plan allows the account owner to buy credits at participating schools for future tuition at current prices. As college education costs show no signs of slowing down, you may save money by prepaying the tuition and fees for your child at today's rates.

There are typically a couple of caveats to be aware of with prepaid plans:

  • Fewer options. Most participating schools are public universities, and you may only apply the funds to a specific school, limiting your options.
  • Residency requirements. Some states have residency requirements for the account owner and beneficiary.
  • Tuition only. While tuition savings can be a benefit, money applied to these plans cannot go toward room and board.
  • Higher education only. Unlike the 529 savings plan, these funds can't be used for tuition at elementary or secondary schools.

You may also want to consider what happens if your child's plans change. If you've prepaid a tuition plan and your child goes to a different school, the credits you've purchased may not transfer to their preferred college. If your child decides not to go to school, you may transfer the plan to another child, put it toward your educational expenses or use the funds and pay the penalty on the earnings.

What are the potential advantages and drawbacks of 529 plans?

Before deciding to invest in a 529 plan instead of one of the other college savings plan options, it's essential to understand the benefits and drawbacks of the plan. Here's what you need to know before you get started.

Advantages of 529 plans

  • Tax advantages. 529 plans allow for tax-deferred growth, tax-free withdrawals and tax-deductible contributions. However, these may be limited by the rules of the state plan you choose.
  • Ownership. As the account owner, you control the funds in the account, and you can set up as many plans as you'd like; there is no limit.
  • High balance limits. 529 plans typically include high total balance limits in the accounts. The total balance limit in accounts varies by state but ranges from $235,000 to more than $500,000.
  • High contribution limits. 529 plans don't have contribution limits. However, according to the IRS, 529s are gifts for tax purposes. In 2022, contributions up to $16,000 ($17,000—2023) per parent qualify for annual gift tax exclusions. Some states may also have annual limits.
  • Flexibility. 529 plans can pay for various needs, from elementary school to post-graduate expenses (including medical and law school). Plus, there is no age limit for using the funds.
  • Locking in costs. For prepaid tuition plans, 529s lock in the prices of attending college.

Drawbacks of 529 plans

  • Plans vary by state. Every state offers at least one 529 plan, but programs can have different fees, contribution limits and restrictions.
  • Guarantees. Double-check how and if the funds are guaranteed if you choose a prepaid tuition plan. Some states may change these plans or close them to new investments due to fluctuations in state budgets.
  • Limited investment options. Investments may be limited based on which state plan you choose.
  • Contributions and student aid. Depending on your plan, contributions may count against student aid. However, a plan owned by a parent typically has a far smaller impact on aid compared with one owned by the student.
  • Watch for fees. Some plans may offer investments with higher fees. Before contributing, learn about the expense ratio of the available investments to get an estimate of potential costs.
  • Minimum contributions. Some plans require minimum distributions to open the plan and to be made each month afterward. Review the requirements to make sure they fit within your budget.

What are qualified and unqualified expenses for 529 plans?

The IRS sets specific restrictions on how the funds in your 529 plans can be used. You can still withdraw money to use on unqualified expenses; however, these withdrawals are subject to state and federal taxes, and you may have to pay an additional 10% penalty on the earnings.

Qualified expenses include:

  • Books and textbooks on course required reading lists.
  • Computers and related equipment used by the beneficiary during the years they are enrolled and primarily for educational use.
  • Room and board costs; if the student is living off campus, the costs can't exceed the school's estimates for campus room and board.
  • Expenses for required fees, books, supplies and equipment for certified apprenticeship programs.
  • Tuition and fees (if utilizing a prepaid tuition plan) as well as up to $10,000 yearly for elementary, middle and high school tuition expenses.
  • Special needs services.
  • A one-time withdrawal of up to $10,000 for student loan repayment.

The IRS offers further guidance on which educational expenses qualify.

How to choose a 529 plan

If you've decided that a 529 plan is a good fit for you and your family, your next question may be, "Where can I open a 529 account, and what's the process?" Here's four things you should know.

1. You can invest in any state's 529 plan, but you may want to start exploring your state's offering—you may get particular tax advantages or residency benefits.

2. Look at the fees, investment options and performance (minus the fees). When selecting a plan, many people choose to strike a balance that minimizes fees and maximizes their potential return on investment.

3. Once you've decided on a plan, you can enroll in it directly or by working with a financial advisor. A financial advisor with experience setting up 529 plans can also help you select an investment plan that fits you and your family's needs.

4. Select the best investment option that meets your risk profile. This may be worth discussing with your financial advisor: Most plans have a few options, ranging from mutual funds to target date plans, which shift the mix of investments from more aggressive to more conservative as your child gets closer to college age.

Most states make it easy to contribute to your plan, offering automatic contributions from your bank account. However, some states have minimum monthly contribution requirements (as well as initial contribution fees), so review these expenses and how they fit into your budget.

You'll also want to consider how much you want to save. That number will depend on your children's age, the college they hope to attend and your budget. A college savings calculator can help you run the numbers.

Make the right decision for you

Before deciding on a 529 plan, take the time to review your options. Consider how the pros and cons align with your family's needs to get a sense of whether it's a good fit. Plans vary by state, and you may find that one state's program works better for you than another—including the one offered by your state.

Connect with a local financial advisor to access expertise, tools and resources to help you and your family prepare for the future.

Offered through a brokerage arrangement with Thrivent Investment Management Inc., 529 college savings plans are not guaranteed or insured by the FDIC and may lose value.

Consider the investment objectives, risks, charges and expenses associated before investing. Read the issuer's official statement carefully for additional information before investing.

Investigate possible state tax benefits that may be available based on the state sponsor of the plan, the residency of the account owner, and the account beneficiary. Consult with a tax professional to analyze all tax implications prior to investing.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.