How Your 529 Plan Can Pay for College

Today, I’m breaking down what a 529 plan is and how it can help pay for your child to go to college.

A 529 plan is a college investment account. You put money in, it grows with the market, and over time you have more dollars available to pay college costs. In many ways, it’s similar to a Roth IRA: you contribute money after paying taxes, but as long as you spend the funds on qualified education expenses (like tuition, fees, room, and board paid directly to the academic institution) you don’t pay capital gains taxes on the growth. That’s a major tax benefit.

It’s also a bit like a traditional IRA, because about 40 states offer a state tax benefit. Here in New Jersey, for example, you can deduct up to $10,000 of your annual contributions as long as your income is below $200,000. That’s another meaningful advantage.

A 529 plan is also similar to a pension in that you don’t control the individual investments. It’s a managed, age-based account. When your children are younger, the money is invested in higher-risk, potentially higher-yield funds. As they get closer to college age, the investments gradually shift to lower-risk, lower-yield funds. This helps protect your savings if the market drops right as your student is ready to start (or is already attending) college.

In New Jersey, there’s also the NJ BEST scholarship, which can be worth up to $6,000 and can be used at any public or private college in the state. Eligibility is based on how long the 529 plan has been open and how much you’ve contributed.

There is a lifetime contribution limit of $35,000 for certain benefits, which isn’t something most families need to worry about. Contributions are also subject to gift tax rules. Even though the money is yours and held for the benefit of the student, it counts as a gift. The annual gift exclusion is $19,000 per person (or $38,000 for a married couple), which usually just means filing a form with the IRS. It counts toward the lifetime gift exemption, which is currently close to $14 million: again, not something most families need to stress about.

If you want to contribute more upfront, you can also “superfund” a 529 plan by making up to five years’ worth of contributions at once: $95,000, or double that for a married couple. This allows you to jump-start the account, though you can’t repeat this every year.

You’re not the only one who can contribute to your child’s 529 plan. Grandparents, aunts and uncles, godparents, and non-custodial parents can all contribute. They can either add money to your existing plan or open their own 529 plan for your child.

How these plans are treated on the FAFSA (the Free Application for Federal Student Aid) is important. A 529 plan owned by a parent and held within the household counts as a parent asset, alongside things like stocks, bonds, and CDs. However, a 529 plan owned by someone outside the household no longer counts as a student asset under the FAFSA Simplification Act of 2020.

Instead, money used from an outside-owned 529 is counted as student income, but only in the year it’s used to pay college expenses. Because the FAFSA uses a two-year lookback, once a student reaches January 1 of their sophomore year (assuming a four-year graduation timeline), they’re no longer in a FAFSA income-reporting year. Ideally, if you can afford to pay the first three semesters yourself, you can then use grandparent- or relative-owned 529 funds for later semesters. At that point, the money doesn’t count as an asset or as income: it effectively disappears from the FAFSA calculation.

What happens if your student doesn’t need all the money in their 529 plan? That’s a great problem to have. Maybe they earn scholarships, graduate early, choose a more affordable college, or the investments perform better than expected. Or maybe they don’t go to college at all.

In those cases, you have options. You can keep the money for future education. You can transfer it to another family member, including siblings, parents, grandparents, aunts, uncles, cousins, or even future children without taxes or penalties. You can withdraw the money for yourself, though you’ll pay income tax on the earnings plus a 10% federal penalty.

More recently, you can also roll unused 529 funds into a Roth IRA for your student. The money becomes theirs, but since it was always intended to help them, it can now support their retirement instead of their education.

Starting a 529 plan early gives you the greatest benefit, because it allows more time for growth. For families with older students, some decide that since the money will mostly be in lower-risk, lower-yield investments, they’d rather fund an IRA instead.

IRAs have their own advantages:

1. They don’t count at all on the FAFSA.
2. IRA funds can be used to pay for college (without an early withdrawal penalty, though capital gains taxes still apply).
3. You control the investments and can choose where you think the money has the best growth potential.

There’s a lot to consider here, and every family’s situation is different. It’s a good idea to consult a financial planner to decide what makes the most sense for you.