529 Plan

A 529 plan is a state-sponsored investment account earmarked for education. Contributions are made with money you have already paid federal tax on, but everything the account earns grows untaxed, and withdrawals spent on qualifying costs are federally tax-free. Many states add a deduction or credit for contributing to their own plan.

Qualifying costs are broader than tuition. Fees, books, required equipment, and room and board for students enrolled at least half-time all count, as do registered apprenticeship expenses. The rules also allow a limited annual amount toward K-12 tuition and a lifetime amount of up to $10,000 per beneficiary toward student loan repayment.

Spending the money on anything else is where it bites. The earnings portion of a non-qualified withdrawal is taxed as ordinary income and carries a 10% penalty, though your original contributions always come back untouched. If the beneficiary wins a scholarship, the penalty is waived up to that amount — the tax is not.

The classic objection is what happens if the child skips college, and it has largely been answered. The beneficiary can be changed to almost any family member, including a sibling, a parent, or yourself, and unused funds can now be rolled into a Roth IRA for the beneficiary subject to a lifetime cap and a minimum account age.

You are not restricted to your home state's plan, but check the state tax break before shopping elsewhere, since that benefit is often worth more than a small difference in fees. A 529 owned by a parent is also treated gently by financial aid formulas compared with an asset held in the student's name.