Overview

Saving for college is about balancing tax benefits, financial-aid impact, and flexibility. 529 plans are the most commonly recommended vehicle because they offer tax-free growth for qualified education expenses and broad beneficiary rules. In my practice working with families over the past 15 years, I’ve seen 529s reduce the net cost of attendance meaningfully when used as part of a broader savings strategy.

This article explains how 529 plans work, the main alternatives, key tradeoffs, and practical planning steps you can take today.

Sources: IRS Publication 970 (Tax Benefits for Education) and Consumer Financial Protection Bureau explain 529 rules and qualified withdrawals (see links below).

How 529 plans work (basic mechanics)

  • Account owner: Usually a parent, grandparent, or other adult who controls the account and the timing of withdrawals. The beneficiary is the student.
  • Tax treatment: Contributions are made with after‑tax dollars. Earnings grow tax‑deferred, and distributions used for qualified education expenses are federal income‑tax free (check state tax treatment for additional benefits) (IRS Publication 970).
  • Qualified expenses: Tuition, fees, required books, supplies, equipment, required room and board (for students enrolled at least half time), certain K–12 tuition (federally up to $10,000 per year), and qualified apprenticeship program expenses (see IRS guidance and state plan rules).
  • Nonqualified withdrawals: Earnings portion is subject to income tax plus a 10% federal penalty unless an exception applies (death, disability, scholarship, or attendance at a U.S. military academy). State penalties may also apply.
  • Types of 529 plans:
  • Prepaid tuition plans: Allow purchase of tuition credits at participating institutions (often state public colleges) at current prices. Less common and often limited by residency or participating schools.
  • Education savings plans: Invest contributions in a selectable menu of mutual funds or age‑based portfolios. These are the dominant form of 529s today.

Practical note: You can change the beneficiary to another qualifying family member without tax consequences. Many families use this flexibility to keep funds in the tax‑advantaged wrapper if one child does not use all the money.

Who can open a 529 and contribution rules

Anyone can open or contribute to a 529 — parents, grandparents, other relatives, and even friends. Accounts are state‑sponsored or state‑administered; you are not required to use your own state’s plan (though state tax benefits often favor in‑state plans).

Certain estate‑planning strategies use the 5‑year gift‑tax election to front‑load contributions (treating a large lump sum as five years’ worth of annual exclusions). Because gift‑tax rules and exclusion amounts change periodically, check current IRS guidance or your advisor before large contributions.

Financial aid and 529s

How a 529 affects need‑based aid depends on who owns the account and the aid formula used:

  • FAFSA (federal student aid): 529 assets owned by a parent are reported as parental assets and are assessed at a relatively low rate in the aid calculation; 529s owned by a dependent student are treated as student assets and have a larger impact.
  • Grandparent‑owned 529s: Historically, distributions from grandparent‑owned accounts counted as untaxed student income in the following year, which could reduce need‑based aid significantly. Recent FAFSA and aid policy changes have modified timing and treatment; check current guidance or consult a financial aid counselor.

In practice, I often recommend parents own the 529 instead of a grandparent doing so to limit negative FAFSA effects and to keep control over distributions.

(See the Federal Student Aid site for current FAFSA rules.)

Alternatives to 529 plans: pros and cons

1) Coverdell Education Savings Account (ESA)

  • Pros: Broader qualified expense definition (includes K–12 and elementary/secondary expenses beyond tuition), investment flexibility.
  • Cons: Low contribution limit (annual cap per beneficiary), income limits for contributors, phase‑outs for higher earners.
  • Best for: Families who need more flexibility for K–12 expenses and have lower balances.

2) Custodial accounts (UGMA/UTMA)

  • Pros: No education restriction — money can be used for anything that benefits the child; straightforward setup.
  • Cons: Irrevocable gift to the minor; assets become the child’s at the age of majority and are counted as student assets (larger FAFSA impact).
  • Best for: Families who want maximum flexibility and are comfortable transferring control to the child at adulthood.

3) Taxable brokerage accounts

  • Pros: Maximum flexibility, no contribution limits or qualified‑expense restrictions, favorable capital gains tax rates for long‑term holdings.
  • Cons: No tax‑free benefit for qualified education withdrawals; potential higher impact on financial aid depending on ownership.
  • Best for: Families who value flexibility, want to use funds for non‑education needs, or are investing after maximizing tax‑advantaged options.

4) Roth IRA (for education use)

  • Pros: Contributions (not earnings) can be withdrawn tax‑ and penalty‑free at any time; under certain conditions, earnings may be withdrawn penalty‑free for qualified higher‑education expenses.
  • Cons: IRA contribution limits and income limits restrict how much can be saved; using retirement assets for education can jeopardize retirement security.
  • Best for: Young adults saving early, or parents who have maxed other tax‑preferred accounts and want a backup option.

5) Loans, scholarships, work‑study

  • Pros: Scholarships and grants do not need to be repaid; loans increase flexibility to pay tuition when needed.
  • Cons: Loans create long‑term debt; scholarships reduce need for savings but are uncertain.
  • Best for: Families who plan a balanced approach — savings plus targeted borrowing.

For more on alternatives and tradeoffs, see our related guides: “College Savings Alternatives When a 529 Isn’t the Best Fit” and “Comparing 529s with Taxable Investment Accounts for College Savings.”

Common planning strategies and traps I see in practice

  • Start early and automate: Small, regular contributions plus age‑based glide‑path investments often outpace ad‑hoc lump sums.
  • Match investment risk to time horizon: Use growth‑oriented allocations for younger beneficiaries and shift to conservative allocations as college approaches.
  • Grandparent contributions: Consider whether a direct contribution to the parent‑owned 529 or a custodial/gift is better for financial aid timing.
  • Avoid using 529 withdrawals for nonqualified expenses unless necessary; taxes and penalties can erode savings.
  • Consider a split strategy: use a 529 for tuition and a taxable or custodial account for expenses you expect to be nonqualified (e.g., computers, travel, summer programs not covered by the 529 rules).

Mistakes to avoid:

  • Assuming all colleges accept 529 funds the same way — verify with the school’s billing office.
  • Ignoring state tax benefits: some states give an immediate deduction or credit for contributions to the state’s plan.
  • Failing to update the beneficiary or beneficiary’s status (e.g., scholarship acceptance) which could trigger a reconsideration of strategy.

Practical examples

Example A — Two children, long horizon
A family with two young children used an age‑based 529 portfolio for each child and contributed steadily. Because they started early and stayed invested, market growth plus tax‑free withdrawals reduced the family’s net college cost. In my work, disciplined monthly investing and avoiding early shifts to cash as markets pull back were keys to this success.

Example B — Near-term pivot
A family with one child entering college had a large 529 balance but received significant scholarship money. We transferred part of the funds to another relative beneficiary and used the remainder for room and board (a qualified expense) to avoid penalties.

How to choose: a short decision checklist

  1. Time horizon: How many years until expenses start?
  2. Primary goal: Only college, K–12 and college, or broader flexibility?
  3. Financial aid concerns: Who will own the account and how does that affect FAFSA/SAI?
  4. Tax priorities: Does your state offer a deduction or credit that makes an in‑state plan advantageous?
  5. Estate & gifting goals: Do you want to reduce taxable estate using front‑loading strategies?

If the answers favor tax‑preferred, education‑only savings and you can tolerate the rules on qualified expenses, a 529 is usually the first tool to consider. If you need more flexibility or have complex estate goals, a custodial account, trust, or taxable account may fit better.

For side‑by‑side comparisons of specific alternatives, see: “Choosing Between 529 Plans and Education Savings Accounts” on our site.

Frequently asked questions

Q: Can I use a 529 for graduate school?
A: Yes. Qualified expenses include tuition and required fees for undergraduate and graduate degrees at eligible institutions.

Q: What happens if my child does not go to college?
A: You can change the beneficiary to another qualifying family member, withdraw the funds (subject to taxes and penalties on earnings), or hold the account for future education needs.

Q: Are contributions tax‑deductible?
A: Contributions are not deductible on your federal return. Many states offer tax deductions or credits for contributions to the state’s 529 plan; rules vary by state.

Q: Can I roll over from a 529 to an IRA?
A: Recent law changes allow limited 529-to-Roth-IRA rollovers under specific conditions and lifetime limits. Consult IRS guidance for the current rules and eligibility.

Next steps and resources

  • Review your timeline and run cost projections: use a college‑savings calculator and estimate total cost in today’s dollars.
  • Confirm state tax incentives: they vary and can change year to year.
  • Talk to a fee‑only financial planner or your tax advisor if you’re considering large contributions, a rollover, or an estate‑planning move.

Author’s note: In my advising work, a practical first step is to open a modest monthly contribution to an age‑based 529 and revisit allocations annually. That approach keeps savings on track without trying to time the market.

Professional disclaimer

This page is educational and does not replace personalized tax, legal, or financial advice. Rules for 529 plans, financial aid, and tax treatment change; consult IRS Publication 970, the Consumer Financial Protection Bureau, the Federal Student Aid office, or a qualified professional for decisions tailored to your situation.

Authoritative sources and further reading