529 plan (aka Qualified Tuition Program)is a savings plan provided by the state (or an educational institution) aimed to help families save up money for their kid’s future educational costs. The “529” name comes from the legal proceedings coming from section 529 of the IRS code, implemented in 1996.

The plan is similar to a Roth IRA in that the earnings grow tax-free and that the money put in is all post-tax money.

Who can you set up a 529 for?

You may set up a 529 to pretty much anyone – even yourself! Most often it is set up for a close relative or friend. If you decide to change your mind about who the funds should go to, you may do so with no penalty.

What restrictions are there on what can you spend the money on?

Once your kid is old enough to attend college, you may withdraw the money to spend on tuition, as long as the cost is towards a qualified education expenses. This includes:

  • Textbooks
  • Computer technologies
  • Printer
  • Software for educational purposes
  • Room and board

The Catch

If you decide to withdraw the money for non-educational expenses, you may face up to 10% in penalties.

Two types of 529 Plans

There are two types of 529 plans – a savings plan and a prepaid plan.

529 Savings Plan

529 Savings Planis much like a 401k or IRA account. Here, you place your contributions into mutual funds or other investments within the stock market.

Prepaid Plan

In a pre-paid plan, you can pay for your kid’s tuition at the current cost. Considering tuitions have been on the rise over the last few decades, this can be a discount of up to 40%. A caveat is that this plan only applies for in-state public schools. Thus, if your beneficiary decides to change his mind and go out-of-state, then you’re out of luck. But if you’re a business owner looking to pass on the family company down to your child, and prestige is not a factor, the 529 prepaid plan may be right for you. Know that there are risks in prepaying. If your beneficiary receives scholarships to a private school, it may end up being cheaper to attend.