529 Plans and the Case for Saving for College Early

Tax News You Can Use | For Professional Advisors

February 17, 2025

A common objective for many families is saving to pay for education for children and sometimes grandchildren. This is not surprising in an era when college costs have been rising much faster than inflation. A Georgetown University Study found that from 1980 to 2020 (roughly one generation), the cost of college rose approximately 169%. In two generations, from 1963 to 2020, tuition costs rose 310%.

A tax-advantaged way to save for college education costs is a state-sponsored 529 plan. Recent changes to 529 plans have made them even more flexible than in the past. This edition of Tax News You Can Use explores the uses of the 529 plan, some recent changes and why families may want to consider funding them sooner rather than later.

What Is a 529 Plan and Why Are They So Popular?

529 College Savings Plans are a tax-advantaged vehicle for saving for future education expenses. Funds contributed to a plan account can grow federal income tax free and withdrawals, if the beneficiary uses them for qualified higher education expenses, are not subject to federal income tax when distributed. There is an additional gift tax bonus available only to gifts to 529 plans: A grantor can “pre-fund” up to five years’ worth of annual exclusion gifts for an individual in one year — This option is not available for other annual exclusion gifts. 529 plans have grown in popularity since 1996, when section 529 of the Internal Revenue Code was enacted as part of the Small Business Jobs Protection Act. The National Association of State Treasurers reported that $412.5 billion in assets were held in 529 plan accounts nationwide as of December 2022.

As the chart illustrates, when you compare making annual exclusion gifts to a 529 plan with contributions to a conventional investment account, the amount available for college expenses is larger in the 529 plan at the end of the ten-year period because of the difference in tax treatment. While it is unlikely that an account will have solely ordinary income or solely capital gains, the projections show that there will be between 6% to 10% fewer assets available for college in a taxable savings account than if the same gifts were made to a 529 plan account. Note that taxpayers who have already started saving for college in a trust or UTMA account may still be able to invest those assets in a 529 account and obtain the tax benefits of 529 planning.

The Power of Early

Given that tax-free growth and accumulation drive the benefits of saving in a 529 plan, the time to start saving is always as soon as possible. The New York Times has reported that research by Morningstar found that the average age of a child for whom a 529 plan account is opened is seven years old. And while starting to save for higher education when a child is in elementary school is a great start, the way to maximize the benefit of the tax-free growth inside the plan is to start even earlier if you have the opportunity. Consider the following comparison of assets available for college based on making a gift of $19,000 to a 529 account when the child is age one compared with age seven and age thirteen.

How to Maximize Savings in a 529 Plan Account

Donors to 529 plan accounts have a secret weapon not available to those who choose alternative ways of giving funds for education. As shown above, 529 plan balances grow bigger if you start earlier. The Internal Revenue Code allows a donor to elect to apply five years’ worth of annual exclusions to a single gift on their gift tax return. That would allow a donor to contribute $95,000 today to a 529 plan and apply the annual exclusions for 2025, 2026, 2027, 2028 and 2029 to it so that it does not use up the donor’s basic exclusion amount. This upfront investment allows additional years of compounding within the tax-advantaged account. A married couple could contribute $190,000 in single year. The following chart shows how that $190,000 contribution at age one would grow over eighteen years using a 5% annual investment return assumption in comparison with five separate annual exclusion gifts in consecutive years.

If the original gift is made at age one, another gift of $190,000 could be made at age six and again at age eleven. Note that the chart assumes investment for a 5% total return for the entire time, rather than shifting to liquid assets leading up to the date of matriculation.

What If I Overfund?

One of the concerns expressed by parents and grandparents who have the means to maximize contributions to a 529 plan is what happens if the funds are not ultimately needed for qualified higher education expenses. This could happen because the child does not go to college, the child becomes disabled, the child receives scholarships, or the child’s college expenses are less than the amount in the plan. Withdrawals that are not for qualified education expenses are generally subject to federal income tax and an additional 10% penalty on the earnings. These concerns have led some families to avoid using 529 plans.

Congress and the IRS have considered these issues and both the initial enactment and later amendments (including the 2022 SECURE 2.0 Act) have created certain safety valves for these situations. These include the following:

1. There is an unlimited ability to change the beneficiary of the 529 plan account to another family member. This means that the funds not needed for a particular beneficiary’s education can be made available for the educational expenses of siblings, parents, cousins or even the beneficiary’s own children. Note that changing the beneficiary can be treated as a gift by the original beneficiary to the new beneficiary.
2. If a beneficiary receives certain kinds of scholarships (tax-free grants or employer assistance, for example) or attends a United States service academy, the beneficiary can withdraw an amount equal to that scholarship from the 529 plan account without penalty (although income tax is due if the amount is not used for education expenses).
3. Under some but not all state plans, a beneficiary can withdraw up to $10,000 from a 529 plan without penalty to pay qualified expenses for K-12 education for a beneficiary.
4. If the beneficiary of a 529 plan is a disabled person, the owner can roll-over up to $19,000 tax-free into an ABLE account for the disabled beneficiary.
5. Under the federal rules and the rules of some states, a beneficiary can withdraw up to $10,000 for the repayment of certain student loans without tax or penalties. Note that the $10,000 is per borrower, so separate distributions can be made for loans owed by the student and loans owed by the parent. The ability to change the beneficiary of the 529 plan account applies in this context too.
6. If the 529 plan has been open for fifteen years or more, the beneficiary can transfer up to $35,000 tax-free to the beneficiary’s Roth IRA. The $35,000 is a lifetime limit on transfers, and it will have to be done over several years based on each year’s limitations for contributions to a Roth. In 2025, that contribution level is $7,000, so it would take five years to move the whole $35,000 from the 529 to the Roth IRA.

The Roth IRA rollover is an attractive proposition as long as the beneficiary of the 529 at the time of the rollover (and note that this can be combined with the ability to move 529 plan funds to accounts for other specified family members) qualifies to make contributions to a Roth (e.g., the beneficiary has earned income).

Roth IRAs grow tax-free while assets are in the account (like a 529 plan). Unlike assets in a traditional IRA or qualified plan, the Roth IRA owner pays no income tax when withdrawing the assets in retirement. Recent college graduates are more likely to have income levels that qualify to make Roth contributions (less than $150,000/single or $236,000/married filing jointly for 2025), but they often lack the cash flow to take full advantage of that opportunity, which allows contribution of up to $7,000 per year. Using 529 plan account funds is a terrific way to jumpstart the young adult’s retirement savings. A 22-year-old 529 account beneficiary who contributes (rolls over) $7,000 per year for five years to a Roth IRA will have over $233,000 at age 62, which they can later withdraw tax-free in retirement.