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 Funds may only be withdrawn for certain educational expenses.
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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.
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:
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.
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.
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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