Your questions about 529s, answered

Publication date:  Sep 24, 2026. The information is accurate as of this date. When we make material updates, we will also update the publication date.

Byline: Alex Michalka

Introduction: The challenge of saving for education

Saving for education, especially college, is one of the most frequently discussed investment goals among Wealthfront clients. Many of our clients are starting families and are committed to helping their children finance a college education. In planning for this goal they face a complex set of savings and investment challenges.

Data compiled by the College Board shows that for the academic year of 2025-2026, the average annual total cost to attend (including tuition, housing and food, book and supplies, transportation, and other expenses) a public four-year in-state college is $30,990 and $50,920 for public four-year out-of-state college. Meanwhile, the average annual total cost to attend a private nonprofit four-year college is $65,470. It’s worth noting that the tuition portion of the student budget has grown significantly over time: Between 1995-1996 and 2025-2026, tuition grew from $5,940 to $11,950 for public four-year in-state students, and from $25,820 to $45,000 for private nonprofit four-year students, after adjusting for inflation (i.e. the 1995-1996 costs are in 2025 dollars).

These figures, combined with the relatively short investment horizon (as compared to retirement planning) frame the challenge of financing a college education. Clients who talk to us about this goal often grapple with several important related questions:

• What kind of account should we use to save for college?
• How much should we save, given the ever-increasing costs of college, the choice between public and private schools, and the complex math of financial aid?
• What kind of investment portfolio is appropriate for college savings given our risk tolerance?
• How should the investment risk be managed as our child approaches college?

This blog is intended to help our clients start to address these issues. The analysis below compares various saving options, focusing primarily on optimizing savings plan performance through increased tax-efficiency. Our analysis concludes that the tax advantages of a 529 account make it a particularly advantageous savings vehicle for college, as well as qualified K-12 and postsecondary expenses.

Comparing Education Savings Account Types

There are four primary accounts used to save for college:

• 529 account
• Coverdell Education Savings Account (ESA)
• Custodial Account (UTMA/UGMA)
• Taxable investing account

Table 1 analyzes each of the four account types based on their tax efficiency, breadth of use and flexibility with regards to control. Tax efficiency is measured using four factors: 

1. The ability to compound investment earnings tax-free
2. The ability to withdraw funds tax-free
3. The ability to receive a tax deduction for contributions
4. The ability to minimize or avoid gift taxes when saving and paying for education

Breadth of use refers to the ability to use the account for something other than education expenses and control flexibility refers to the ability of the person who funds the account to limit how much control the student/beneficiary can exercise over the account.

Table 1: Comparison of account types as of 2026

* While most states exempt gains on qualified withdrawals from income tax, Alabama only exempts qualified withdrawals from the Alabama 529 Plan; the earnings portion of withdrawals from out-of-state plans are subject to Alabama state income tax.

Compound tax-free

529 and Coverdell accounts provide tax-advantaged growth, with investment earnings generally exempt from federal income tax when distributions are used for qualified expenses. In contrast, taxable and custodial accounts generally subject “unearned” income (dividends, interest payments, and realized capital gains) to annual taxes. However, for the 2026 tax year, the first $1,350 of unearned income from custodial accounts is generally exempt from federal taxes for a beneficiary with no earned income, though lower filing thresholds may apply in certain states. The next $1,350 is taxed at the child’s tax rate, which is typically lower than the parents’ tax rate. The remainder of income in a custodial account is typically taxed at the parents’ tax rate under the Kiddie Tax.

Withdraw tax-free

Withdrawals from 529 and Coverdell accounts are tax-free as long as they are used for qualified expenses. For 529 plans, qualified expenses include certain K-12 and higher education expenses, as well as certain qualified post secondary credentialing expenses. Beginning in 2026, the annual limit for qualified K-12 expenses from 529 plans is $20,000 per beneficiary, increased from $10,000 previously (there is no maximum for higher education expenses). For Coverdell ESAs, there is no dollar limit on K-12 expenses.

For a taxable account, taxes incurred on capital gains realized at liquidation may further reduce the amount that can be applied to fund education. In a custodial account, unearned income exceeding the applicable Kiddie Tax threshold may be taxed at the parents’ tax rate..

Tax deductions for contributions

There are no federal tax deductions or credits for 529 contributions, but many states offer an income tax deduction or credit on contributions to 529 plans. 529 plans are authorized under the federal tax code and each 529 plan must be sponsored by an individual state, leaving the specifics of a tax deduction to the discretion of the individual states. Table 2 shows that of the 43 states with an income tax, 38 states and the District of Columbia offer a deduction or credit for 529 contributions. Only nine of those states offer a deduction for contributions to both out-of-state and in-state 529 plans (account owners may contribute to most states’ 529 plans regardless of their state of residency). The remaining 29 states and the District of Columbia require contributions to an in-state plan to receive a tax benefit. The majority of these states also limit the size of the deduction or credit.

Table 2: States that offer 529 income tax benefits

* Donors over age 70 can deduct an unlimited amount of 529 contributions.

Table 3 lists states that do not offer any 529 tax breaks either because they don’t have a state income tax or they don’t offer benefits.

Table 3: States that do not offer 529 income tax benefits

There are no federal or state income tax deductions or credits for contributions to Coverdell, taxable, or custodial accounts.

Gift tax consideration

While paying for a child’s education rarely incurs gift tax, several gift tax rules shape how families pay for education. As shown in Table 1 above, the annual gift tax exclusion can be applied to 529, Coverdell, and custodial account contributions. Of the three, only 529 accounts allow pre-funding (also known as superfunding) of up to five years of exempt gifts at inception (and again at subsequent five year intervals) to maximize the benefit of tax-advantaged compound growth. This pre-funding requires the account owner to use five years’ worth of annual gift-tax exemptions, meaning that exemption cannot be used for any other gifts to the same beneficiary for five years. Once assets have been contributed, they are not subject to gift tax at withdrawal.

A taxable account remains owned by the account owner (minors cannot own non-custodial accounts) and therefore has no gift tax implications at funding. At withdrawal, tuition paid from a taxable account directly to a school is qualified for an unlimited educational exemption from gift tax. However, payments for room, board and other costs technically do not qualify for this exemption. Families are generally required to file a gift tax return if this amount, combined with other gifts to the same beneficiary, exceeds the annual exclusion (currently $19,000 as of 2026).

Beneficiaries and account control

529 accounts were created as an incentive to help parents fund their children’s education. They may only be used without penalty to fund qualified K-12, college, graduate school, and post-secondary credentialing expenses. However, they offer significant flexibility with regards to whose expenses the account funds. The account owner retains control of the 529 account they set up. Account owners may even change the beneficiary to another qualified family member at any time. For example you may create an account for a nephew and then switch it when you have your own child. This allows you to get started much earlier if you so desire.

Coverdell account owners also have the ability to change beneficiaries. Unlike 529 accounts, Coverdell accounts are required to distribute any remaining assets to the beneficiaries once they turn 30. These distributions may be subject to taxes and penalties if they are not used for qualified expenses.

Custodial accounts have no restrictions on permitted use, but can only be used to benefit the original named beneficiary. When funding a custodial account, the account owner makes an irrevocable gift to that beneficiary and cannot change beneficiaries in the future. In addition, the beneficiary takes ownership of the account and can do with it what they wish once they reach the Age of Transfer (usually 18 or 21, depending on the state).

A 529 account therefore provides parents greater control over how the account is used.

Impact on financial aid eligibility

Many families may worry that a 529 plan will reduce their potential financial aid and result in a higher Student Aid Index (SAI). Although parent-owned 529 assets are included in the SAI calculation, parent-owned 529 and taxable accounts generally have a smaller impact on the SAI than assets held in the student’s name, such as a custodial account. In addition, while withdrawals from taxable accounts may result in taxable capital gains that could affect future SAI calculations, qualified withdrawals from a parent-owned 529 account generally are not counted as income for this purpose. Therefore, holding assets in a parent-owned 529 account generally has a relatively limited impact on the SAI, particularly compared with assets held in the student’s name.

Combining a 529 account with federal college tax deductions and credits

For some families, federal tax deductions and credits for college expenses can be more valuable than the tax benefits from a 529 account. IRS rules prohibit families from using 529 accounts to pay for specific college expenses and then claiming a federal income tax credit or deduction for the same expenses. However, because these deductions and credits are subject to income limits and their total value is limited relative to the cost of college, many families should consider combining them with a 529 account that funds the majority of their college costs to help maximize tax efficiency.

There are two federal tax deductions or credits for college expenses: the American Opportunity Tax Credit and the Lifetime Learning Credit. As of 2026, the maximum annual value of these benefits is a $2,500 credit and a $2,000 credit, respectively. Families can only claim one of them per student per year. The highest income limit across the two programs is $180,000 for married couples filing jointly, meaning the median married Wealthfront clients earning $240,000 do not qualify for any of these deductions or credits. They also only can be claimed for tuition and fees incurred by the taxpayer(s) or their dependents (so grandparents, for example, typically cannot claim them for their grandchildren’s college expenses).

Parents who do qualify can maximize these tax benefits using the following funding strategy. By using the 529 account to fund the majority (but not all) of their college expenses they can also claim a valuable, but limited tax benefit. For example, if a child’s college education costs $30,000 per year net of financial aid, the parents can fund $27,500 of that expense using a 529 account. They can then claim a $2,500 tax credit if they pay for the remaining expenses using other (non-529) savings or income. In contrast, if the family paid the full $30,000 using a 529 account, they would not be eligible to claim a deduction or credit.

Summary

Our analysis shows that, relative to other account types when it comes to saving for education, a 529 account can offer significantly higher after-tax returns than a taxable account. Table 4 below illustrates how $10,000 invested in a 529 account for 18 years and withdrawn for qualified expenses has the potential to be worth 11% more than the same amount invested in a taxable account (assume no tax-loss harvesting activities within this account), excluding any potential benefit from a state tax deduction. This hypothetical analysis assumes that each account earns an average pretax return of 4% per year, 25% of the average annual return is from qualified dividends and no capital gains are recognized until liquidation. It also assumes a combined long-term capital gain federal and state marginal tax rate of 18.07% for a married couple who jointly earn an annual income of $240,000 (the median Wealthfront married couple client) and live in Pennsylvania.

Pennsylvania offers a relatively generous state income tax deduction for 529 contributions and allows the deduction for contributions to any 529 plan. We use Pennsylvania to illustrate the potential additional benefit of a state tax deduction. If the same married couple from Pennsylvania earning $240,000 were to contribute the value of that deduction to their 529 account, we estimate they will end up with 13% more than what they would have with a taxable account. This estimate is based on the Pennsylvania 529 account owner’s ability to deduct contributions up to a limit of $38,000 for married filing jointly ($19,000 per taxpayer), with a marginal state income tax rate of 3.07% (compared to an average of 5.22% for couples earning $240,000 across the 38 states in Table 2 as of 2025). For purposes of this analysis, we also assume that the state tax savings reduce the taxpayer’s federal itemized deductions, resulting in additional federal income tax. This makes the estimated value of the deduction 3.07% x (1 – 24% marginal federal income tax rate) = 2.33%, or $233 based on the $10,000 invested in the account. An investor would therefore have to deposit 11-13% more to their taxable account for its expected value to equal the 529 account’s expected value after 18 years. The amount of the 529 account advantage will depend on whether the state in which the account owner resides offers a tax deduction, the state income tax rate, and the limit on the amount that can be deducted.

Table 4: Value of $10,000 invested in 529 vs. Taxable account for 18 years

*The cost basis increase in a taxable account is equal to the cumulative value of reinvested after-tax dividends. See additional chart disclosures in the footer.

As you can see, the tax-efficiency of a 529 account can provide a significant after-tax performance advantage. The advantage grows when you add the ability to pre-fund five years worth of contributions gift tax-free (known as “superfunding”) and the flexibility to change beneficiaries. If you have any funds left over after your child finishes college, there are several ways you can continue taking advantage of the funds without generally triggering federal income tax or the 10% additional tax on earnings: Change the beneficiary to another qualifying family member such as a sibling or grandchild, use the funds for graduate studies, roll over to a Roth IRA in the beneficiary’s name up to the $35,000 lifetime limit subject to annual contribution limits and other restrictions, or pay off up to the $10,000 lifetime limit toward qualified student loans per beneficiary.