529 Plans Demystified: Saving for College Tax-Free

College costs have grown faster than inflation for decades. A year at a private university now exceeds $60,000. Public universities aren't far behind. For parents in their 40s watching their children approach college age, 529 plans offer one of the most powerful tools for building an education fund—if you understand how to use them.

What Is a 529 Plan?

A 529 plan is a tax-advantaged savings account designed specifically for education expenses. Named after Section 529 of the Internal Revenue Code, these plans offer significant tax benefits that make them the gold standard for college savings.

There are two types of 529 plans:

• 529 Savings Plans: The most common type. You contribute money, choose investments, and the account grows. This is what most people mean when they say "529 plan."
• Prepaid Tuition Plans: Allow you to purchase future tuition at today's prices at specific schools. Less flexible but can lock in costs at participating institutions.

This article focuses on 529 savings plans, as they offer the most flexibility for most families.

The Tax Benefits

The 529's power lies in its tax treatment:

Unlike retirement accounts, there's no federal tax deduction for 529 contributions. But the tax-free growth and withdrawal more than compensate, especially over a decade or more of saving.

Contribution Limits

529 plans have unusually generous contribution limits:

• No annual contribution limit: Unlike IRAs with their $7,000 cap, 529s have no annual limit
• Lifetime limits: Most states set lifetime limits between $235,000 and $550,000 per beneficiary
• Gift tax considerations: Contributions above $18,000 per year (2024) count against your lifetime gift tax exemption, but there's a special rule...

The 5-Year Gift Tax Averaging Rule

Here's where 529s get interesting for grandparents or parents with significant assets. You can contribute up to 5 years' worth of gifts at once—$90,000 per beneficiary ($180,000 for married couples)—without gift tax implications.

This "superfunding" strategy allows you to front-load a 529, giving the money maximum time to grow tax-free. A $90,000 contribution when a child is born could grow to over $350,000 by age 18, assuming 8% annual returns.

What Qualifies as an Education Expense?

529 withdrawals are tax-free when used for qualified education expenses:

• Tuition and fees at accredited institutions
• Room and board (with some limitations)
• Books and supplies required for courses
• Computers and related equipment
• Internet service
• K-12 tuition (up to $10,000 per year)
• Apprenticeship program expenses
• Student loan repayment (lifetime limit of $10,000)

The expansion to include K-12 tuition, apprenticeships, and student loan repayment has made 529s more versatile than ever.

Investment Options

Most 529 plans offer a menu of investment options:

• Age-based portfolios: Automatically shift from aggressive to conservative as the child approaches college age. The "set it and forget it" option.
• Static portfolios: Fixed allocation options ranging from conservative to aggressive. You choose and maintain your allocation.
• Individual funds: Some plans let you build your own portfolio from underlying index funds or actively managed funds.

For most families, age-based portfolios offer the best combination of appropriate risk management and simplicity. They function like target-date retirement funds but calibrated for a college timeline.

Choosing a 529 Plan

You can use any state's 529 plan, regardless of where you live or where your child attends school. This opens up some strategic decisions:

Key factors to compare:

• Expense ratios: Lower is better. Top plans charge 0.10-0.20% annually.
• Investment options: Look for low-cost index fund options.
• State tax benefits: Calculate the actual dollar value of any deduction.
• Minimum contributions: Some plans require as little as $25 to start.

What If My Child Doesn't Go to College?

This is the fear that keeps some parents from using 529s. But the flexibility is better than you might think:

• Change the beneficiary: Transfer to a sibling, cousin, niece, nephew, or even yourself. The money stays in the family.
• Use for other education: Trade schools, apprenticeships, and graduate school all qualify.
• Roll to a Roth IRA: As of 2024, up to $35,000 can be rolled into a Roth IRA for the beneficiary (after 15 years and subject to annual Roth contribution limits).
• Take a non-qualified withdrawal: You'll pay income tax plus a 10% penalty on earnings—not ideal, but you don't lose everything.

The new Roth IRA rollover option is a game-changer. Even if your child gets a full scholarship or chooses not to attend college, the money isn't trapped.

How Much Should You Save?

The amount depends on your goals:

• Full ride at private university: $250,000-$400,000 per child
• Four years at public university: $100,000-$150,000 per child
• Partial coverage (expecting financial aid, scholarships, or student contribution): $50,000-$75,000 per child

Don't let the big numbers paralyze you. Even $100/month for 15 years, with market growth, can provide meaningful help with college costs.

The Zen Approach to College Savings

Here's a principle that might seem counterintuitive: don't sacrifice your retirement to fund your child's education. Your kids can borrow for college; you can't borrow for retirement.

After you're on track with retirement savings, 529 contributions can accelerate. Many families find a rhythm: maximize employer 401(k) match first, then fund 529s, then increase retirement contributions further.

Remember too that you don't have to save 100% of projected college costs. Financial aid, scholarships, work-study, and reasonable student loans can all play a role. The goal isn't to eliminate all college costs—it's to make them manageable.