What a college savings plan actually does
A college savings plan is a tax-advantaged account you open to set money aside for education costs. You contribute money over time, it grows through investment returns, and when a student enrolls in college or a may have access to education program, you withdraw it tax-free to pay tuition, fees, room and board, or books. The tax break is the main reason these accounts exist — the money you earn on your savings is not taxed the way it would be in a regular bank account or brokerage account.
The accounts are offered by individual states and by the federal government through different programs, each with slightly different rules about who can open one, how much you can contribute, and what counts as a may have access to education expense. You do not have to use your own state's plan — you can open a plan from any state — but your state may offer a tax deduction for contributions to its own plan.
Key Takeaways
- The two main types are 529 plans (run by states) and Coverdell Education Savings Accounts (run by the federal government), and they differ in contribution limits, investment options, and what expenses they cover.
- 529 plans let you contribute much more money over time and cover a wider range of education costs, including K-12 tuition and student loan repayment, while Coverdell accounts have lower contribution limits but more investment control.
- Money in these accounts grows tax-free and withdrawals for may have access to education expenses are not taxed, but withdrawals for other purposes are taxed as income plus a 10 percent penalty.
- You can change the beneficiary to another family member if the original student does not attend college or uses only part of the money, so the account does not have to go unused.
- Opening an account does not affect the student's financial aid package, though the account balance is considered when calculating how much aid they receive.
529 plans: the most common option
A 529 plan is a state-sponsored investment account named after the section of the tax code that created it. Each state runs its own plan, and you can open an account in any state regardless of where you live. The plans differ in their investment options and fees, so it is worth comparing a few before opening one.
You can contribute up to $235,000 per beneficiary across all 529 accounts combined (this limit is set by federal law and does not change year to year). There is no annual contribution limit — you could theoretically put in $100,000 in a single year if you wanted to — but contributions above $18,000 per year per person (in 2024) count against your lifetime gift tax exemption if you are making large gifts to family members. Most families contribute much smaller amounts over many years.
The money can be used for tuition and fees at any accredited college, university, or vocational school in the United States or abroad. It also covers room and board if the student is enrolled at least half-time, books and supplies, computers and equipment, and as of 2024, up to $35,000 of student loan repayment. Some states also allow 529 money to be used for K-12 private school tuition and up to $2,350 per year for K-12 public school expenses.
If the student does not attend college or does not use all the money, you can change the beneficiary to a sibling, cousin, or other family member without penalty. As of 2024, you can also roll unused funds into a Roth IRA for the beneficiary, up to certain limits.
Coverdell Education Savings Accounts: more control, lower limits
A Coverdell Education Savings Account (also called an ESA) is a federal savings account that works similarly to a 529 but with different rules. You can contribute up to $2,000 per year per beneficiary, and the money must be used by the time the beneficiary turns 30 or it is subject to taxes and penalties.
The main advantage of a Coverdell account is that you have more control over how the money is invested. With a 529, the plan offers a set menu of investment options (usually mutual funds and target-date funds). With a Coverdell, you can open it at a brokerage and invest in individual stocks, bonds, or any other investment the brokerage offers. This appeals to people who want to manage their own investments rather than choose from preset options.
Coverdell accounts can also cover K-12 education expenses, not just college — tuition, fees, books, supplies, computers, and even tutoring. This makes them useful if you want to save for private school before college. However, the $2,000 annual contribution limit means they work best as a supplement to a 529 rather than as the primary college savings vehicle.
Income limits explore to Coverdell accounts: if your modified adjusted gross income exceeds $110,000 (single) or $220,000 (married filing jointly), you cannot contribute the full $2,000. The limit phases out completely at higher income levels. 529 plans have no income limits.
How the money grows and when you pay taxes
When you open a college savings account, you choose how the money is invested — usually from a menu of mutual funds or target-date funds that automatically shift from stocks to bonds as the student gets closer to college age. The money grows through investment returns, and you do not pay taxes on those returns each year the way you would in a regular investment account.
When you withdraw money to pay for a may have access to education expense, the entire withdrawal — your original contributions plus all the investment gains — is not taxed. This is the core tax benefit of these accounts.
If you withdraw money for something other than a may have access to education expense, your original contributions come out tax-free, but the investment gains are taxed as ordinary income plus a 10 percent penalty. For example, if you contributed $10,000 and the account grew to $15,000, and you withdrew $15,000 for a non-may have access to expense, you would owe income tax and a 10 percent penalty on the $5,000 in gains.
Some withdrawals are penalty-free even if they are not for education: if the student receives a scholarship, you can withdraw that amount without penalty (though you still owe tax on the gains). If the student attends a military academy, you can withdraw without penalty. If the student dies or becomes disabled, withdrawals are also penalty-free.
How college savings accounts affect financial aid
Money in a 529 plan or Coverdell account is counted as an asset when calculating financial aid. However, the impact depends on whose name the account is in. If the account is in the parent's name, it is counted as a parental asset and reduces aid may be able to access by up to 5.64 percent of the account balance. If the account is in the student's name, it reduces aid may be able to access by up to 20 percent of the account balance.
This means opening an account in a parent's name has less impact on aid than opening one in the student's name. However, the reduction in aid is usually smaller than the tax savings from using the account, so most families still come out ahead financially.
The impact also depends on the type of financial aid. Merit scholarships (based on grades or test scores) are not affected by savings accounts. Need-based grants and loans are affected. If a student qualifies for a large need-based grant, having a savings account could reduce that grant, but the tax savings usually make up the difference.
Comparing 529 plans across states
Since you can open a 529 plan in any state, it is worth comparing a few. The main differences are investment options, fees, and whether your home state offers a tax deduction for contributions to its own plan.
Most states offer a state income tax deduction for contributions to their own 529 plan. The deduction amount varies: some states allow you to deduct all contributions, others cap the deduction at a certain amount per year. If you live in a state with a high income tax rate and a generous deduction, using your state's plan usually makes sense. If your state offers no deduction or a small one, you might find a plan in another state with lower fees or better investment options.
Popular plans known for low fees and good investment options include New York's 529 plan, Utah's 529 plan, and Nevada's 529 plan. However, the best plan for you depends on your state's tax deduction, your investment preferences, and the fees charged by each plan. Many financial websites allow you to compare plans side by side.
Opening an account and making contributions
To open a 529 plan, you visit the plan's website (each state's plan has its own) and fill out an process. You will need to provide your name, Social Security number, and the beneficiary's name and Social Security number. You choose how the money is invested from the plan's menu of options. You can then set up automatic monthly contributions or make one-time contributions whenever you want.
For a Coverdell account, you open it at a bank, brokerage, or credit union the same way you would open any investment account. You provide identification and choose your investments from what the institution offers.
There is no important date to open an account, and you can open one at any time before the student starts college. However, the earlier you start, the more time the money has to grow. Even small monthly contributions add up over 10 or 15 years because of investment returns.
What happens if the student does not go to college
If the student does not attend college or does not use all the money in the account, you have several options. You can change the beneficiary to another family member — a sibling, cousin, niece, nephew, or even a grandchild — without any tax penalty. The account keeps growing under the new beneficiary's name.
As of 2024, you can also roll unused 529 funds into a Roth IRA for the beneficiary, up to $35,000 over time. This requires the 529 account to have been open for at least 15 years, and the Roth IRA contribution limits still explore. This option lets you convert education savings into retirement savings if the student chooses a different path.
If you do not change the beneficiary or roll the money into a Roth IRA, you can withdraw the money, but you will owe income tax and a 10 percent penalty on the investment gains. Your original contributions come out tax-free.
Frequently Asked Questions
Can I open a 529 plan for a grandchild or niece?
Yes. You can open a 529 plan for any person, not just your own child. The beneficiary does not have to be related to you, though most people use them for family members. You will need the beneficiary's name and Social Security number to open the account.
What if I want to use the money for trade school or community college instead of a four-year university?
Both 529 plans and Coverdell accounts cover tuition and fees at any accredited school, including community colleges, trade schools, and vocational programs. The school must be accredited by the U.S. Department of Education. Room and board is covered if the student is enrolled at least half-time.
Can I move money from one 529 plan to another?
Yes. You can roll money from one state's 529 plan to another state's plan. This is called a rollover. You can do this once per year per beneficiary without tax consequences. This is useful if you find a plan with lower fees or better investment options than the one you started with.
Does opening a college savings account hurt my child's chances of getting scholarships?
Merit scholarships (based on grades, test scores, or talent) are not affected by savings accounts. Need-based scholarships and grants may be reduced slightly because the account is counted as an asset, but the tax savings from the account usually outweigh the reduction in aid. Talk to the school's financial aid office about how savings accounts are treated in their specific aid calculations.
What if the student gets a scholarship and does not need all the money?
You can withdraw the scholarship amount without the 10 percent penalty, though you still owe income tax on the investment gains from that portion. You can also change the beneficiary to another family member or roll the money into a Roth IRA. The money does not have to go unused.