Understanding 529 Plans: A Guide for Families

For many families, the cost of college is one of the largest financial challenges they will face. A four-year degree can easily run six figures, and that number continues to climb each year. Many parents and grandparents have heard about 529 plans – perhaps from friends, financial news, or online research – but are not quite sure how they work or whether they are the right choice.

The short answer: 529 plans are one of the most powerful tools available when saving for education expenses and recent changes have made them even more flexible than before. But, like any financial tool, they work best when used properly and with a clear understanding of the rules.

This guide covers what families need to know about 529 plans – from the fundamentals to the various ways funds can be used – and common mistakes that can cost thousands of dollars. Whether considering options as a new parent, looking to contribute as a grandparent, or planning for a teenager approaching college age, understanding 529 plans can make a significant difference in long-term education funding.

What is a 529 Plan?

A 529 plan is a tax-advantaged savings account specifically designed for education expenses. Think of it like a 401(k) or IRA, but instead of saving for retirement, the funds are earmarked for education costs.

How It Works

The mechanics are straightforward: account owners contribute after-tax dollars into the plan and choose from a menu of investment options (typically mutual funds or age-based portfolios), and the money grows over time. The real power comes from the tax treatment: earnings grow tax-free, and withdrawals are tax-free when used for qualified education expenses.

Contributions must be made in cash (not securities) and are considered gifts from a tax perspective (not taxable to the beneficiary). The annual exclusion gift limit – currently $19,000 per person per year—applies, but there is a special provision to “superfund” the 529 account with up to five years’ worth of contributions in a single year.

Three Types of 529 Plans

There are three types of plans:

Education Savings Plans are the most common type. These work like investment accounts where contributions are invested in selected portfolios. The account value fluctuates based on market performance, and funds can be used at virtually any accredited college or university nationwide.

Prepaid Tuition Plans allow families to lock in today’s tuition rates at participating colleges, typically state schools. These are less common and have more restrictions, so this guide focuses primarily on education savings plans.

529 ABLE Accounts (from the Achieving a Better Life Experience (ABLE) Act of 2014) function similarly to 529 savings plans but are specifically designed for people with disabilities. These accounts are generally less common and come with their own set of rules and restrictions, but have similarly generous flexibility for using the money

The Tax Advantages

This is where 529 plans truly shine. While contributions are not deductible from federal taxes, many states offer a state income tax deduction or credit for contributions (unfortunately, North Carolina does not). The invested funds grow tax-free year after year – that means no taxes on dividends, interest, or capital gains. When the money is withdrawn for qualified education expenses, those withdrawals are completely tax-free at both the federal and state levels.

To put this in perspective: if a family invests $50,000 that grows to $150,000 over 18 years, that $100,000 in growth is never taxed if used properly. In a regular taxable account, those gains would be subject to capital gains taxes if sold for education expenses, as well as tax drag from interest, dividends, and distributions each year on the IRS Form 1099.

Who Controls the Account

One important feature: the account owner (usually a parent or grandparent) maintains control of the funds, not the beneficiary. This means the student cannot simply cash out the account at age 18 and use it for non-education purposes. This is unique to 529s: the contribution is a completed gift (and is out of the donor’s estate) but still under the owner’s control. The account owner decides when and how the money is distributed.

What Can 529 Funds Actually Be Used For?

One of the most common questions about 529 plans involves what the money can and cannot cover. The list of qualified expenses is broader than many people realize, but there are also important limitations to understand.

Traditional College Expenses

The core qualified expenses include:

Tuition and fees at any accredited college, university, vocational school, or other post-secondary institution eligible for federal financial aid. This includes both undergraduate and graduate programs.

Room and board for students enrolled at least half-time. For students living on campus, the actual amount charged by the school qualifies. For off-campus housing, withdrawals are limited to the school’s published cost of attendance for room and board.

Books, supplies, and equipment required for coursework. This includes textbooks, lab fees, and necessary computers or software if required by the school.

Special needs services for special needs beneficiaries in connection with their enrollment or attendance.

Study Abroad for students taking part in eligible programs through the university managing their program.

Newer Qualified Uses

Recent changes from the TCJA in 2017, SECURE Act, and the OBBBA in 2025 have significantly expanded how 529 funds can be used:

K-12 tuition up to $20,000 per year beginning in 2026 for elementary or secondary public, private, or religious schools.

Vocational and Skilled Trade programs registered and certified with the Department of Labor, including fees, books, supplies, and required equipment.

Professional and Continuing Education programs to pay for exam prep fees for certifications (CPA, law, nursing, etc.) as well as funds for maintaining such licenses.

Student loan repayment up to $10,000 lifetime for the beneficiary and up to $10,000 for each sibling.

Roth IRA rollovers represent one of the most significant recent changes. After a 529 plan has been open for at least 15 years, the owner can roll over up to $35,000 (lifetime limit) into the beneficiary’s Roth IRA, subject to annual Roth contribution limits. This potentially addresses a longstanding concern about “overfunding” a 529 plan – leftover education funds can now become retirement savings without triggering taxes or penalties. Important limitations: capped at a total of $35,000, contributions made in the last five years (and their earnings) are not eligible for rollover, the rollover counts against the beneficiary’s annual Roth IRA contribution limit, and the beneficiary must have earned income to qualify.

What’s NOT Covered

Understanding what does not qualify is equally important:

Transportation costs, including car payments, gas, insurance, or flights home, do not qualify, even if necessary for attending school.

Health insurance premiums are not qualified expenses, even when required by the school.

Room and board beyond the school’s cost of attendance figures. Luxury apartments that exceed these limits will result in partially non-qualified withdrawals.

Sports, clubs, and activities that are not part of the degree program requirements, even when school-sponsored.

Less than half-time enrollment disqualifies room and board expenses, though tuition and fees still qualify.

Why This Matters

Using 529 funds for non-qualified expenses triggers income tax on the earnings portion of the withdrawal, plus a 10% penalty on those earnings. Keeping careful records and understanding these boundaries helps families avoid unnecessary taxes and penalties while maximizing the account’s benefits.

Understanding Your Withdrawal Options

Knowing what expenses qualify is only part of the equation. Understanding all the ways funds can be withdrawn from a 529 plan and the tax implications of each helps families make informed decisions in various scenarios.

Qualified Withdrawals (Tax-Free)

This is the ideal scenario and what 529 plans are designed for. When funds are withdrawn and used for qualified education expenses (as outlined in the previous section), both the principal and earnings come out completely tax-free at the federal level and typically at the state level as well.

The key is maintaining proper documentation. Keep receipts, tuition statements, and records that clearly show the expenses were qualified and occurred in the same tax year as the withdrawal.

Non-Qualified Withdrawals (Taxable + Penalty)

When 529 funds are withdrawn for expenses that do not meet the qualified criteria, tax consequences apply. The earnings portion of the withdrawal becomes subject to ordinary income tax, plus a 10% federal penalty on those earnings. The principal (original contributions) always comes out tax-free since it was contributed with after-tax dollars. An important note: these distributions will come out pro rata, meaning there is no ability to choose between withdrawing only the basis and not the earnings.

Penalty Exceptions

There are several situations where the 10% penalty is waived, though income taxes on earnings still apply:

Scholarship received: Withdrawals up to the amount of a tax-free scholarship can be taken without penalty. This provides relief when a student receives substantial scholarship funding that reduces the need for 529 funds.

Attendance at a U.S. military academy: The cost of attending service academies (Air Force Academy, Naval Academy, etc.) can be withdrawn penalty-free since these institutions do not charge tuition.

Death or disability of the beneficiary: If the beneficiary passes away or becomes disabled, withdrawals are penalty-free.

Use of education tax credits: Families can withdraw an amount equal to qualified education expenses used to claim the American Opportunity Tax Credit or Lifetime Learning Credit, though this requires careful coordination to avoid double-dipping on tax benefits.

Changing the Beneficiary

Rather than taking a non-qualified withdrawal, account owners can change the beneficiary to another qualifying family member. This is a tax-free modification with no penalties. Qualifying family members include siblings, parents, children, cousins, nieces, nephews, in-laws, and even the account owner.

This flexibility means funds do not go to waste if one child does not need all the money – it can simply be redirected to another family member’s education expenses.

Roth IRA Rollover

As discussed in the previous section, eligible funds can now be rolled into a Roth IRA for the beneficiary. This provides another penalty-free and tax-free option for leftover funds, subject to the specific rules and limitations outlined earlier.

Returning Withdrawals

If a withdrawal is taken and then circumstances change (such as a tuition refund), the funds can be returned to the 529 account within 60 days without tax consequences, like IRA rollover rules. This safety valve protects against accidental nonqualified withdrawals.

Strategic Considerations

Understanding these options allows for strategic planning. For instance, if a child receives a partial scholarship, families might choose to take a penalty-free (but taxable, though only on the earnings portion) withdrawal for that scholarship amount. Other families may decide to preserve “leftover” 529 funds for graduate school or transfer the funds to a sibling. Each family’s situation will dictate the optimal approach.

Common Mistakes to Avoid

Even well-intentioned families can make costly errors with 529 plans. Here are the most frequent mistakes and how to avoid them.

Mistake #1: Waiting Too Long to Start

The power of a 529 plan comes from tax-free compound growth over time. Families who wait until their children are in middle or high school miss out on years of potential growth. Even small contributions made early can grow substantially over 15-18 years.

A $5,000 contribution made when a child is born could grow to over $14,000 by age 18 (assuming a 6% average annual return). That same $5,000 invested when the child is 10 years old would only grow to about $7,100. The eight-year difference costs nearly $6,000 in growth.

The fix: Start contributing as early as possible, even if the amounts are modest. Regular small contributions beat large contributions made late in the game.

Mistake #2: Poor Timing of Withdrawals

Taking 529 distributions in a different calendar year than when qualified expenses are paid can create tax headaches. For example, withdrawing funds in December 2024 to pay tuition due in January 2025 can result in complications when filing taxes, as the IRS requires expenses and withdrawals to match within the same tax year.

The fix: Align withdrawals with when expenses are actually paid. Keep detailed records, including receipts, tuition bills, and withdrawal statements. When in doubt, take distributions in the same year expenses are incurred.

Mistake #3: Not Adjusting Investment Risk Over Time

Leaving a 529 plan in aggressive stock investments when the beneficiary is close to college age exposes the family to market risk at the worst possible time. A market downturn in the year before college starts can devastate savings just when they are needed.

The fix: Most 529 plans offer age-based portfolios that automatically become more conservative as the beneficiary approaches college age. These can be an excellent “set it and forget it” option. Alternatively, manually adjust the investment allocation to become more conservative (more bonds, fewer stocks) as college approaches.

Taking the Next Step

529 plans remain one of the most effective tools available for funding education expenses. The combination of tax-free growth, tax-free withdrawals for qualified expenses, and increased flexibility through recent rule changes makes them worth thoughtful consideration for most families saving for education costs.

The key is to start early, understand the rules, and avoid common pitfalls that can diminish the benefits. Whether just beginning to explore college savings options or looking to optimize an existing 529 plan, having a clear strategy makes all the difference.

Every family’s situation is unique: income levels, state tax benefits, expected education costs, and overall financial goals all play a role in determining the best approach. While 529 plans offer powerful advantages, they work best as part of a comprehensive financial plan that considers all aspects of a family’s financial picture.

For personalized guidance on whether a 529 plan is right for your situation, which plan to choose, or how to maximize an existing account, reach out to discuss your specific circumstances. Making informed decisions today can save thousands of dollars and provide peace of mind as education expenses approach.

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