National 529 College Savings Plan Day: What Is It? How Can You Spend the Tax-Free Earnings?

Each year, National 529 College Savings Plan Day draws awareness to the tax-advantaged way of putting money away for education costs. However, the possibilities for spending the money varies depending on the plan.

Several 2020 presidential candidates have addressed the issue of debilitating student debt, which affects an estimated 40 million people. Among the solutions presidential hopefuls have floated are debt forgiveness, free education and greater transparency within higher education and loan systems.

To help ease the burden of student loans, some parents put money aside each year for their children's education. While polls found the most popular method of saving is to use a general savings account, 529 plans have grown in popularity over the years. However, many people still remain unaware that 529 plans are even an option for education savings.

What Is a 529 Plan?

529 plans, also referred to as "qualified tuition plan," are tax-advantaged savings plans sponsored by states, state agencies or educational institutions. Earnings are federally tax-exempt, according to the Department of Education, and most states exempt earnings from state income tax.

There are two types of 529 plans: Prepaid tuition plans and education savings plans. Both serve as a way to save for a child or beneficiary's education, but differ in their methods.

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Graduating students arrive for the Columbia University 2016 Commencement ceremony in New York on May 18, 2016. National 529 College Savings Plan Day, occurring on Wednesday, draws attention to the tax-free earnings that can be used for college expenses. TIMOTHY A. CLARY/AFP/Getty Images

Prepaid tuition plans allow people to purchase units or credits at higher education institutions at current prices to be used in the future by the beneficiary. The credits are purchased for participating colleges or universities, which the Securities and Exchange Commission noted are usually public and in-state. However, the Department of Education reported it may be able to be used for an equal payment to private or out-of-state institutions.

The second type of plan is an education savings plan. It serves as an investment account that can be used for future qualified higher education expenses. Similar to a Roth401(k) or Roth IRA, plans offer several investment options and funds will rise and fall based on the investment's performance.

Generally, the accumulated funds, according to the Securities and Exchange Commission, can be used at any participating college or university, regardless of its location. Up to $10,000 per year can also be used to pay tuition at elementary or secondary schools.

Education savings plans differ on the state, but Saving for College noted that a person can enroll in any state's plan, not just the state where a person is a resident.

How Can You Spend the Money You Save?

Approved expenses vary based on the selected plan. Prepaid tuition plans, according to the Securities and Exchange Commission, can be used for tuition and mandatory fees, but not room and board.

Education savings plans, however, can be used for tuition, fees, books, supplies, equipment, computers and sometimes room and board. Student loan payments, student health insurance and transportation are not considered necessary costs, according to Saving for College, and therefore are not eligible.

Technically, a person can use the funds accumulated in an education savings plan for any expense they choose, although it will come at a price. The money put into the account, or the contribution, was made with after-tax dollars, therefore will never be subjected to a penalty. However, the earnings of the account are not taxed. So, if they are used for a non-qualified distribution, they are subject to income tax, a 10 percent penalty and any additional state penalties.

If a beneficiary doesn't need the funds, they can be withdrawn with the payment of income tax and penalties, although there are exceptions to the penalty fees.

National 529 College Savings Plan Day: What Is It? How Can You Spend the Tax-Free Earnings? | U.S.