Most parents want their children to get the best higher education possible, but that dream comes with a high price tag. The growing costs of college mean parents who intend to help foot the bills need to plan, and as early as possible.
One way to save for college tuition is through a 529 college savings plan, named for the relevant section of the federal tax code. Also known as a “qualified tuition plan,” this is a type of tax-advantaged account that allows savings to grow through investment. Funds may only be withdrawn for certain educational expenses.
While 529 plans have been around for more than 20 years, many parents still aren’t sure how they work. Yet 529 plans can be an effective way to save for your child’s education while taking advantage of tax benefits.
Here’s what you need to know about 529 plans and whether opening one is the right move for you.
Related: Your Parent PLUS Loan was denied. Now what?
529 Plan Basics
There are two kinds of 529 plans, and every state offers at least one.
1. Prepaid Tuition Plan
A prepaid tuition plan allows you to prepay tuition and fees at certain colleges and universities at today’s prices. Such plans are usually available only at public schools and for in-state students. Only a few are accepting new applicants.
The main benefit of this plan is that you could save big on the price of college by prepaying before prices go up. And contributions are considered gifts, so deposits up to $15,000 a year qualify for the annual gift-tax exclusion.
The risk is that your child may not attend a participating college or university, so the prepaid tuition plan may pay less than if the beneficiary attended a participating school. Also, if your state government doesn’t guarantee the plan, you may lose the payments you’ve made if the state runs into budget shortfalls.
Prepaid tuition plans may charge an enrollment fee and ongoing administrative fees.
The plans usually can’t be used for room and board, though Florida Prepaid plans, for example, offer a prepaid dormitory plan of two semesters of dorm fees for each year of state university coverage. The Florida prepaid plans, guaranteed by the state, can be applied at schools in state, out of state, and at public or private schools around the country or even the world.
A plan can be transferred to another eligible student, or payments can be refunded.
2. Education Savings Plan
The second type of 529 plan is an education savings plan. Here’s how it works:
Making contributions
Contributions are flexible, meaning you can save monthly, quarterly, annually, or deposit a lump sum. Beyond parents making regular payments, 529 plans can be a clever way for the extended family to give a meaningful gift on birthdays or holidays.
Contributions are not deductible on the federal level, but lots of states provide tax benefits for saving in a 529 plan, such as deducting contributions from state income taxes or giving matching grants. Check your local tax laws to see if you qualify.
Investing your funds
Once you make contributions, a possible next step is to invest your funds. You will likely have a range of investment options to choose from, including mutual funds and exchange-traded funds, which vary from state to state.
You may want to tailor your choices to the date you expect to withdraw the money. You can possibly be more aggressive if you have a longer timeline but may sway more conservatively if you only have a few years. One option is to choose a target-date fund, which would automatically adjust your portfolio to become more conservative as your child’s college years approach. That usually means a greater share of stocks initially and more bonds and cash over time.
Making withdrawals
Money can be withdrawn tax-free from a 529 plan to pay for any “qualified higher education expense,” which includes tuition, fees, books, computers, and room and board. You can make withdrawals as long as your child is enrolled at least half-time at an accredited school, regardless of where in the United States it is, and occasionally abroad. (Starting in 2018, parents began being able to also withdraw up to $10,000 a year to pay for K-12 tuition expenses.)
If you withdraw money for the above expenses, you won’t have to pay federal income tax, and often state income tax, on your earnings. If you withdraw the funds for other reasons, you’ll have to pay taxes, as well as a 10% federal tax penalty on the earnings. There are some exceptions to the penalty. You won’t need to pay it if the beneficiary gets a scholarship, enrolls in a U.S. military academy or dies. But taxes would still need to be paid on the earnings in those scenarios.
It is possible to change the beneficiary of a 529 plan if the original one no longer needs it, according to Edmit, a resource for college financial planning. For example, you can switch to a younger child if your oldest got a scholarship.
How 529 Plans Compare to Other Options
Compared to other methods of saving for college, 529 plans offer certain benefits. By investing the funds, this account gives your money the chance to grow over time. If you just leave your savings in cash or even a high-interest savings account, you may actually be losing money as the years go by, as it likely won’t keep up with inflation.
The 529 plan also has advantages when it comes to calculating financial aid. When you fill out the Free Application for Federal Student Aid (FAFSA), the account is considered an asset. If the parent owns it, only up to 5.64% of the amount saved counts when the government calculates the “expected family contribution” in deciding on the financial aid package. (If the student owns the plan, up to 20% of the savings can count in the calculation.)
The bottom line is that while a 529 plan may slightly reduce available financial aid, it will likely save much more overall by reducing the number of loans you or your child need to take out.
If you put your college savings in an online IRA, that won’t be counted as a parental asset on the FAFSA since it’s a retirement account. The 529 plan, though, comes with more tax benefits. Specifically, you can withdraw both contributions and earnings any time from a 529 plan without paying taxes or penalties, as long as it’s for qualified educational expenses.
With a Roth IRA, you can withdraw your contributions at any time, also without taxes or penalties. But you generally must be at least age 59½ and have had the account for at least five years to withdraw earnings tax- and penalty-free. Unlike 529 plans, you can only contribute if you fall below a certain income threshold, and there’s a limit to how much you can put in each year ($6,000 for most individuals in 2021, or $7,000 if 50 or older).
Additionally, some 529 savings plans allow you to deduct contributions on your state income taxes, while any contributions to Roth IRA accounts are with after-tax dollars.
Choosing a 529 Savings Plan
Every state offers a 529 savings plan, but not all are created equal. When trying to find the best 529 college savings plan, you may want to think about the tax benefits and the fees.
First, find out whether you qualify for a state income tax deduction or credit for your contributions, based on your state of residence and the plan. Check your state laws and consult a tax professional to learn more about your particular situation.
Some states, such as New York, only offer deductions to in-state taxpayers who use their plan. Other states, including Pennsylvania, allow residents to take a deduction regardless of which state’s plan they use. Some states, like Indiana, offer income tax credits instead of deductions. And other states, such as North Carolina, don’t offer any deductions for 529 contributions.
The next thing you could consider is the fees associated with your plan, which could include enrollment fees, annual maintenance fees, and asset management fees. Some states let you save on fees if you have a large balance, contribute automatically, are a state resident or opt for electronic-only documents.
The Takeaway
Ah, a college degree, something that 70% of jobs will require by 2027, by at least one informed estimate. Saving for college could be eased with a tax-advantaged 529 plan. It’s worth looking into the two prongs of the plan.
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How to set up a college fund
It’s no secret that college tuition is growing at exorbitant rates in the U.S., and it seems as if there is a near-constant stream of headlines shouting the latest updates in the rising cost (and debt) facing Americans.
The average cost of tuition varies depending on whether the school is private or public. According to the College Board, these were the average inflation-adjusted costs across school types since 1971, including both tuition costs and fees for room and board:
• $48,510 at private, four-year, nonprofit schools
• $37,430 at public, four-year, state schools for out-of-state students
• $20,790 at public, four-year, state schools for in-state students
• $12,320 at public, two-year schools
And typically, tuition costs and room and board aren’t the only expenses college students will usually need to cover. There are textbooks and other school supplies, the cost of traveling to and from school for breaks and any additional living expenses.
As a parent, sometimes just thinking about the cost of college for your kid (or kids) can feel bleak. Thankfully, there’s no time like a bad time to start thinking about ways to save for your child’s education.
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The common advice is: there’s no time like the present to start saving. Even starting with a small amount each paycheck could make a dent when you’re looking at a tuition bill 10 or 18 years down the line. If you are in the early stages of parenthood, college may feel far off now, but time can fly.
There are a few savings plans and investment accounts that are specifically designed to help people save for their child’s education expenses.
As you get serious about saving for your children’s education, which some suggest starting within the first six months of your child’s life, one of these accounts may be worth considering.
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These accounts are named after an IRS code section and give parents the option to save for college in the name of a child while providing certain tax advantages. There are two kinds of 529 Plans, prepaid tuition plans and education savings plans.
Prepaid tuition plans let individuals buy future credits or course units at participating colleges or universities. These credits are used to help cover the cost of tuition for the beneficiary. Most prepaid tuition plans have residency requirements and are often sponsored by state governments.
Education savings plans are investment accounts that can be used to save for the beneficiary’s qualified education expenses. The funds can be used to pay for higher education or private elementary or high schools. Money is taxed when it is contributed to the account, but it can then grow tax-free.
You can’t contribute more money than necessary to cover education expenses, and there are no annual contribution limits set by individual states. There are, however, aggregate limits to 529 plan balances, which vary depending on the state.
California has the highest aggregate limit, at $529,000, and Georgia and Mississippi have the lowest, at $235,000. While there are no contribution limits, it is important to note that in certain circumstances there may be additional taxes involved if contributions to a single beneficiary are more than $15,000 during the year.
If the child decides not to go to school, the account can be rolled over into the name of another family member. If the funds aren’t used for education-related expenses, there may be taxes and penalties.
Generous family and friends can also contribute to a child’s college savings plan. They may choose to make deposits to an existing 529 account or set up one themselves, naming a beneficiary of their choosing.
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This account has more limitations but may offer more features for some. Individuals who have a modified gross adjusted income (MAGI) that falls below $110,000 ($220,000 if filing jointly) may be eligible to save for college using a Coverdell Education Savings Account.
There can be up to $2,000 in contributions for a single beneficiary in a given year. Contributions are made after taxes and must be made in cash. Typically, the funds can be withdrawn without a fee to be used for qualified education expenses.
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This custodial account allows your child to own stocks (just like an adult) and mutual funds. The custodian still controls the account until the minor reaches legal age. Note that it’s not tax-free. It also may reduce the amount of financial aid eligibility.
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Although generally used for retirement savings, IRAs can at times be used to pay for the cost of college. There are two types of IRAs: Traditional and Roth. The main difference between the two:
• Roth IRA: The taxes on the account are paid up front and money withdrawn in retirement is generally tax-free.
• Traditional IRA: Taxes are paid when the money is withdrawn.
Generally, to make fee-free withdrawals from an IRA, the account holder needs to be at least 59 ½ years old. But Roth IRAs can be used to pay for qualified education expenses including tuition, books and supplies. Individuals can generally avoid the 10% early withdrawal fee if the account has been open for at least five years or if it is used for qualified education expenses.
Keep in mind that while there may not be an early withdrawal fee, the earnings withdrawn will still be subject to income tax.
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Even after years of diligent saving, paying the full cost of college tuition isn’t an option for some families. There are a few options to fill the gaps and help students pay for college.
Students getting ready to start college or those who are already enrolled could look into options like scholarships, grants, or private student loans.
Consider filling out the Free Application for Federal Student Aid (FAFSA). This is the first step in qualifying for federal aid including scholarships and grants, work study and federal student loans.
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These can be a powerful asset when paying for college since it’s money that doesn’t have to be paid back.
Scholarships are typically merit-based and can be offered through a variety of different types of organizations like local nonprofits, corporations, or even sometimes directly from universities. There are a number of searchable databases that compile different scholarship opportunities.
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These are also sources of funding that don’t need to be repaid. Unlike scholarships, grants are typically need-based.
The US Department of Education offers federal grants to students, including Pell Grants, Teacher Education Assistance for College and Higher Education (TEACH) and even Iraq and Afghanistan Service Grants.
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The federal work-study program provides part-time jobs for undergraduate, graduate and professional students with financial need. These jobs allow them to earn money to help pay education expenses.
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There are two types of student loans: federal and private. Federal student loans are awarded as a part of your financial aid package and can either be subsidized or unsubsidized.
Subsidized student loans are awarded to eligible undergraduate students based on need. The federal government covers the interest on these loans during the time the student is in school at least half-time, during the six-month grace period after leaving school and during deferment periods.
Unsubsidized student loans are not awarded based on financial need, and are available to both undergraduate and graduate students. The borrower is responsible for paying the interest on a Direct Unsubsidized Loan from the time of disbursement. If the borrower chooses not to pay the interest while in school, during grace periods, or while in deferment, the interest will accrue and be added to the loan principal.
Private student loans are borrowed from a privately owned lending institution. Typically, to get a private student loan, lenders will evaluate the borrower’s credit history, which isn’t the case with most federal student loans. This is why some borrowers rely on a co-signer to secure private student loans.
Typically, borrowers will be required to begin making payments on private student loans right away, even while they are currently attending school.
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Some parents might consider taking out a parent student loan to help their kids pay for college. The federal government makes Direct PLUS loans available to parents and graduate students. The current interest rate on a Direct PLUS loan is 7.08% and it’s fixed for the life of the loan. It’s recommended to exhaust all federal benefits first.
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Saving for your child’s education is important, but so are your other financial goals and priorities like setting up an emergency fund and saving for retirement. A realistic financial plan and budget could be a useful tool to help you as you work toward each of your goals.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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