Should You Create a 529 College Savings Plan for Your Kids?

Young adult friends smile and laugh after the graduation ceremony

SDI Productions / Getty Images

Higher education costs feel like they are constantly on the rise. On top of that, student loan rules and regulations are constantly shifting, meaning parents might not know what this means for the cost of college. While some students qualify for financial aid, scholarships, and grants, not all do. And even these aid mechanisms may not cover every expense, including the cost of living and housing.

What can parents do to prepare? “Given the costs of education increasing, start to save and invest for these costs," says Will Rainey, the author of "Grandpa's Fortune Fables." "The power of compounding from saving over years and tax advantages can reduce the required contributions substantially, compared to not saving in advance.” College savings might come in many forms, but most American families consider a 529 plan first.

“A 529 savings plan offers a way for households to save for college in a tax-efficient manner,” explains Raymond J. Weiss, a certified financial planner and CEO of The Ways to Wealth. He says that 529 plan contributions grow earnings tax-free. "Even better, when used for qualified educational expenses, distributions are tax-free. You can get a tax deduction or credit for contributing in some states,” he shares.

What Is a 529 Savings Plan?

A 529 college saving plan allows parents to save for future college costs while limiting tax liability. They are state-sponsored, but you don’t have to choose your state’s plan. For example, a resident of California can sign up for a Utah 529 plan, and vice versa.

There are two main types of 529 plans.

Types of 529 Plans

Education Savings Plans: These work like any other investment plan, such as 401(k)s and retirement plans, which invest money in high-return assets, such as stocks and mutual funds. Returns on investment are based on market performance.

Prepaid Tuition Plans: Also referred to as a “guaranteed savings plan,” pre-paid tuition plans allow parents to pay some or all the tuition for an in-state institution. Parents lock in today's tuition costs and pre-pay towards them.

Parents who start saving early might have no clue in which state their kid will eventually enroll in college. It can be tough to choose among the options. Most parents want to know if a state-run 529 plan will mean that their child can only go to a university in that state. That depends on the type of 529 plan you choose, Weiss says. “If you're saving using a 529 savings plan, qualified education expenses are eligible regardless of which state your child goes to school," Weiss continues. "If you're using a prepaid tuition plan, those can restrict your school choices. Restrictions vary by state, with some limiting you to only public and in-state schools, while others have more flexible terms.” He also notes that most prepaid tuition plans have been phased out.

Parents should do their research on all the available plans. If children are old enough to share their likes and dislikes, get them in on the planning too. Tweens and teens can help narrow a wide array of choices to define the plan that best fits their future interests. Additionally, Weiss advises that parents review fees, investment options, and tax advantages to decide.

Key 529 Features to Review

Fees: Review the expense ratios of the funds offered and any account or maintenance fees that may be charged.

Investment Options: Consider: What investment options does your state plan have? What type of control do you get if you're a hands-on investor? Are there age-specific plans that adjust investments over time?

Tax Advantages: Look into: Does your state provide a tax deduction or credit for contributing to a 529 plan? Is it required that you contribute to your state's program, or can you contribute to any state's plan?

Reasons to Have a 529 Savings Plan

Many parents are so stumped about which plan to choose that they never do. There are a variety of good reasons to get over the hump and commit. Here is why a 529 plan could be right for your family.

It is tax-advantaged.

A 529 allows you to save money and grow it tax-free to pay for qualified educational expenses. Your earnings are free from federal income tax, and contributions get reinvested automatically. There are other potential tax credits and breaks for contributions that could help lower your taxable income over time.

It's a potentially high-return investment.

Depending on the plan, you can invest in stocks, mutual funds, and other market-based options, allowing maximum returns. Socking money in a savings account for ten years might seem safe, but that money loses value with inflation. High-return investments are ideal for long-term spending needs.

It gives you investment flexibility.

Most 529 plans provide a variety of professionally managed investment portfolios. Age-based portfolios can automatically change from more aggressive to more conservative investments as your child gets closer to the year of college enrollment. You can also choose Multi-, Single-, and guaranteed fund options. These choices align with your risk tolerance, timeline, and investment preferences.

You can use it to repay student loans.

The SECURE Act now permits the use of 529 plans to pay off up to $10,000 of beneficiary student loans and an additional $10,000 in student loans for each sibling.

You can use it for school anywhere.

These plans are not just for university or college. You can pay for vocational schools nationwide and abroad, as well as private primary and secondary schools. Those paying tuition for K-12 graders can also benefit.

Downsides of a 529 Savings Plan

“I would not be surprised if more families believe that their children gaining work experience, rather than higher education, could be a better (financial) outcome for many career choices,” Rainey says. If you’re a parent who isn’t so sure if your kid will ever go to college, then a 529 savings plan probably isn’t the right investment for you. Here are a few other reasons to pass.

The penalties can be steep.

529 rules are strict. The most prominent one is that you must use the funds in the account for qualified educational expenses. If you opt to withdraw the funds for a different purpose, you will attract hefty penalties. “Earnings on non-qualified withdrawals are subject to a 10% tax and federal and state income tax,” says Weiss.

It could hurt your child's chance of getting financial aid.

When calculating your child's eligibility for need-based financial assistance, the cash in a 529 account can work against them—the higher the balance, the lower the aid, but much depends on who owns the account. If the student is the account holder and s/he applies for need-based financial aid, colleges and universities consider the 529 plan as money the family has available to pay for tuition. The availability of funds indicates that the student doesn't need as much financial assistance and s/he is expected to make a higher contribution to their own educational expenses. This expected contribution is weighted higher when the college saving account is in the student's name. If the 529 plan is in the parents' name, the expected contribution is lower.

It could feel restrictive.

Imagine you selected a plan thinking that your child would want to be a creative writing major at the college in town, but now they want to go to medical school out of state. You’d experience delayed buyer’s remorse. But parents must cut themselves some slack. They are usually starting these plans a decade before their kid even knows what college is. The bad part is that the financial incentive of a well-funded 529 plan might pressure students to limit study options to lower debt outcomes, even if they have talents or new interests that could be honed at a higher-cost institution.

Alternatives to a 529 College Saving Plan

If you’re still not sold, there are many other options to consider. Some parents invest in rental property early in their children’s lives, hoping that the income would eventually cover annual college expenses when the time is right. Others work with grandparents to sock away cash in beneficiary or joint accounts, which are out of sight of college financial aid advisors. Here are some of the most popular alternatives to a 529 plan.

High-Yield Certificates of Deposit (CD)

The returns may not be as high as 529 plans. However, CDs allow for predictable returns available on specific timelines. Parents might create CD ladders for their child’s period of study. This means investing in multiple CDs that will mature at predictable intervals of six months or one year, just on time to make college tuition payments.

IRAs

The primary purpose of the Individual Retirement Account or Arrangement (IRA) is to save for retirement, but it is possible to use it for higher-education expenses—though you'll want to be cautious. "If one exhausts their IRA for education expenses, it leaves them less for retirement without much time to make up those contributions,” Weiss says. Parents and students can borrow for college, but not for retirement. So, he doesn’t recommend withdrawing from an IRA to cover tuition and university-related expenses.

Taxable Brokerage Accounts

If you are an experienced investor, these accounts might appeal. A brokerage account allows you to invest in stocks, bonds, exchange-traded funds (ETFs), cryptocurrency, and futures. If you build your portfolio wisely, you could make returns that exceed those of a 529 plan. “They're not as tax-friendly, but you get way more flexibility,” Weiss says. “This flexibility comes in two ways. First, you have much more control over what you invest in, and second, what you can do with the money at the time of withdrawal. This is a sound option if you're not sure if your child will even go to school.”

A Word From Verywell

Overall, 529 college savings plans are viable options for people looking to grow tax-advantaged savings for educational costs. The power of compound interest and starting early can put parents and students in a strong financial position. Rainey says that parental contributions towards college can have untold benefits. “Starting their adult lives off without a large debt hanging over them can not only help them financially but also help them from a mental wellbeing point of view,” he offers.

Rainey also says that parents should share their decision-making process with their kids, so that young people can grasp personal finance and savings lessons early on in life. "[Kids can] witness compound interest at work and see how money goes through ups and downs. This experience gives them an advantage in life,” he explains.

No matter which plan parents choose (or don’t), they can use their 529 plan journey to teach their kids financial literacy fundamentals: budgeting, savings, debt, inflation, compound interest, and more.

Was this page helpful?
4 Sources
Verywell Family uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. U.S. Securities and Exchange Commission. An introduction to 529 plans.

  2. College Savings Plan Network. 529 Plan Advantages and Benefits.

  3. College Savings Plan Network. 529 Planning Tools.

  4. Charles Schwab. 529 Accounts: When a Child Doesn't Go to College.