Why 529 plans are worth it for saving for college

529 plans are one of the best ways to save for your child's college education. These state-sponsored investment accounts offer tax-free earnings and withdrawals that can be used for tuition, books, computers and more.

Initially, the funds could only be used for educational expenses. You'd pay income tax and a stiff penalty if you withdrew money for another reason. That could be a real problem if your child didn't go to college or didn't need all the money for education.

However, that restriction was adjusted in 2024 and money in a 529 plan can now be rolled into a Roth IRA account without a tax penalty. CNBC Select discusses some of the best ways you can take advantage of your 529 plan.

A 529 college savings plan, also known as a qualified tuition program, is an investment account with tax-deferred earnings and tax-free withdrawals. Initially, the funds had to be spent on post-secondary education, but over the years the parameters expanded to include tuition for kindergarten through high school, continuing education, apprenticeships and up to $10,000 in student loans.

Each state offers its own 529 plans (except Wyoming), though most are available to all US residents. In-state account holders may enjoy special benefits, like tax deductions and matching grants.

There are two main types of 529 plans: Education savings plans, which grow tax-deferred and have tax-free withdrawals if used for educational expenses, and prepaid tuition plans, which enable account holders to pay current tuition rates for future attendance at specific state institutions.

Originally, any withdrawals from a 529 plan not used for educational expenses were subject to federal income tax plus a 10% penalty on the earnings portion of the distribution. Since January 2024, however, unused funds from a 529 plan can be rolled over into a Roth IRA account tax-free, in essence turning it into a retirement account. 

A Roth IRA from Charles Schwab allows you to contribute after-tax money with no monthly service fee or minimum deposit requirement. There are no commission fees for stock and ETF trades and no transaction fees for thousands of mutual funds.

The change is one of many updates to retirement savings resulting from the Secure 2.0 Act, passed in December 2022. There are still some restrictions on 529 plans: The account must have been open for at least 15 years before rolling over into a Roth IRA, money contributed in the last five years is not eligible and the Roth IRA account owner must be the 529 plan beneficiary.

Any money rolled over is subject to yearly Roth IRA contribution limits and there is a lifetime transfer cap of $35,000.

529 plans can help you save for your child's college education while earning some helpful tax breaks. These tax-advantaged 529 plans come in two main types: education savings plans and prepaid tuition plans.

An education savings plan is an investment account used to save for a beneficiary's future education expenses. This type of 529 plan is pretty flexible and can be used at most educational institutions, regardless of state or if it's public or private. These accounts often invest in a mix of different assets, but the specifics will differ by plan. Any withdrawals made for qualified higher education expenses will not be federally taxed and could get some state-level advantages.

Prepaid tuition plans are generally less common than the 529 savings plan as they aren't as flexible. Prepaid tuition plans allow you to pre-pay future tuition costs, often at public, in-state institutions. These are typically not as flexible as many require you to be a resident of the state that offers the plan — if you attend a school outside of that state, you might not get the full benefits of your plan.

Benefits of a 529 plan

One of the biggest benefits of a 529 plan is the potential tax breaks. Any interest earned will grow tax-deferred, and if spent on qualifying education expenses, can be withdrawn tax-free. 529 plans also have fairly large caps on your contributions, with the upper limit generally between $300,000 to $500,000 for each beneficiary.

Thanks to the SECURE Act passed in December 2019, payments towards a qualified loan are considered a qualifying educational expense. You can pay up to $10,000 per beneficiary of qualified student loans using funds from your 529 account. The same benefit can also be applied to each of the beneficiary's siblings.

529 plans also provide a range of options, as each state offers at least one plan, and these plans are often open nationwide. A bonus with 529 plans is that they are pretty flexible, covering many different education-related expenses, and you can also roll over up to $35,000 of unused 529 funds to a qualifying Roth IRA account without any tax penalties.

529 plans frequently appeal most to those who are saving for someone's future education. This is often parents and grandparents, but since 529 plans accept contributions from anyone, both family and friends can chip in.

Since a 529 plan can be used at any institution that accepts federal student aid programs, this includes those pursuing graduate programs and other options for continuing their education like trade or vocational schools.

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