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529 College Savings Plan – Best Way to Save for Your Child’s College Education?

By Kira Botkin

529 college savings piggy bankSaving for your children’s college tuition might seem like an unavoidable necessity. Financial aid doesn’t help everyone, and with education expenses rising, college scholarships aren’t going to cover everything. How much thought have you given to saving for your child’s education?

For many couples, planning for college is part of everyday budgeting. For others, there just never seems to be enough money available to start saving. Your child will be going to college before you know it. If you have five years left or even fifteen, don’t wait to start saving. Start today. When you are ready to take the plunge, make sure that you take a look at a 529 savings plan. Investing in a 529 plan is one of the most efficient ways to save for your kids’ college costs.

Recent graduates who come out of school with even a little bit of student loan debt face an enormous burden in the real world. Amid the challenge of a job search, being saddled with student loan debt is no way to kick off financial adulthood. The more advance savings that you help with, the better off your kids will be when they head off to the workforce.

By being smart with how you finance your child’s education, you can drastically minimize the costs your child will incur for a college education. Parents – and grandparents too – need to consider a few financial aid and tax rules before picking a smart plan. Contributions to a 529 plan are tax-deductible, and if you plan properly, your child can use the money for college-related expenses tax-free.

What Is a 529 College Savings Plan?

These plans are named after the section of the IRS code that authorizes college savings: section 529. Basically, it’s a savings account designed specifically for college tuition and other related educational costs. They’re your family’s federally approved tax break for college savings. These qualified tuition plans can provide special tax advantages such as state income tax deductions and tax-deferred growth.

Most of these plans are operated by individual states, and sometimes by the universities themselves. Since the tax benefits can vary by state, talk with your accountant or consult your state’s online information to get the details.

You can name yourself as the account holder and your child as the beneficiary, which ensures that the money will be used for your child’s educational expenses. The two types of 529 plans are the college savings plan and the prepaid tuition plan.

Types of 529 Plans

1. College Savings Plans

College savings plans are investment plans that you can use for expenses at any college nationwide. In a college savings plan, you have the flexibility to select the appropriate portfolio based on your investment goals and risk tolerance. Most college savings plans are managed by an independent mutual fund company, so plans vary from conservative to risky, and your rate of return will vary based on your investment selections.

When you contribute to a 529 plan, you can choose to deposit funds through a direct deposit, which allows you to “set it and forget it.” For me, this is the best way to save and make sure I am contributing enough. Plus, once I knew what plan I wanted, it only took about ten minutes on the phone and online to get everything set up. While some plans have a minimum contribution, these requirements are usually very low.

Most states will let you deduct your contributions from your adjusted gross income, lowering your tax burden. In Maryland, for example, you can deduct $2,500 of your contributions. You can take this deduction once per beneficiary, so if you’re saving for two kids, you can deduct $5,000 of the money you save. Some states, however, have lower maximums, like Georgia’s limit of $2,000, and some other states offer no tax deductions at all.

You don’t have to be limited to investing in your own state’s plan. You have the geographic flexibility to participate in other states’ plans. For example, you could live in Ohio, invest in a 529 plan in Florida, and send your child to college in California, and you would still be good to go.

These contributions, however, aren’t eligible for federal income tax deductions. Your account earnings are exempt from federal taxes as long as you use the funds for college expenses.

2. Prepaid Tuition Plans

Prepaid tuition plans are savings plans that allow you to pay for future university tuition prices at today’s rates. Under a prepaid plan, you make fixed payments for a fixed time period, and the state guarantees the cost of college tuition when your child attends college. Today’s payments lock in tomorrow’s prices.

Prepaid savings plans typically have age restrictions and require you to be a resident of the state in which the plan is established. The guaranteed rate only applies to in-state schools. If your child chooses an out-of-state-school, you can use the money you’ve saved, but you’ll be responsible for the difference between what you’ve saved and the higher out-of-state tuition rate.

These plans are also tax-deductible for your state taxes, and the earnings are free from both federal and state taxes. You can select a prepaid tuition plan that covers a minimum of one semester to a maximum of four years.

college tuition piggy bank

Disadvantages of 529 Plans

1. Tied to Tuition
Keep in mind that if you put your money into a 529 savings plan, that money must be used for college tuition costs. Think it’s not a big deal? It can be. What if your child decides he or she doesn’t want to attend college? Or what if you need this money for an emergency?

While there are some exceptions to this rule for emergencies, you’ll face penalties when you use this money for non-tuition expenses. In a sense, you are “locked-in” when using a 529 plan, so while it’s smart to save, don’t overdo it.

2. Risky Business
With a 529, you can’t avoid the fees and internal costs that come with most investment vehicles. Similarly, you’ll also have to worry about the volatility of stocks and bonds. As we learned during the recent crisis – and from the trouble in earlier decades too – there’s no guarantee on investment accounts. Despite the expected annual returns you’re looking for, you can also end up dealing with an ill-timed loss when your child is in high school. The best way to avoid this risk is to start early, so you can front-load the riskier stock assets and gradually shift to less volatile bonds and cash as college approaches.

3. No Guarantees
Most prepaid tuition plans aren’t guaranteed, believe it or not. Each state has its own fine print, and yours may explain that if the plan is underfunded for any reason, then your prepaid credits don’t really transfer. And many state plans are underfunded.

Most of these state plans are based on the state’s ability to reinvest your money in the hopes of getting returns greater than the increase in tuition rates. If over the next ten or twenty years the tuition rate rises by 6.5%, but the investments can’t keep up with that hike, you may be left with virtually worthless investments.

The most likely next step would be the 529 administrators appealing to the state government for money to bring the fund back to 100%. Unfortunately, some states can’t help and they turn down new investors. Other states, like Illinois, take the unusual step of doubling down, and increasing their risk profile to try to get a higher return.

4. Not the Only Option
While 529 plans have advantages, you may be able to find the same tax benefits in other investment options that don’t have the tuition-only restriction. For example, if you are in your forties and have a young child, the age at which you could begin withdrawing funds from a Roth IRA, Roth 401k, or traditional 401k might coincide with the time when your child will be ready for college. You could get some major tax benefits without being held to using your money only for tuition.

Managing Financial Aid

The complexities of applying for and qualifying for financial aid are inevitable. With a 529 plan, you can’t just research the tax and timing issues, you need to consider the advantages and drawbacks of different strategies when it comes to financial assistance. Focus on these three issues:

1. Children’s Assets Count Against Them for Financial Aid
A college will look closely at the amount of assets that are in your children’s names when they apply for financial aid. Children are expected to contribute up to 20% of money held in their names to help offset the cost of their college tuition bills. Parents, on the other hand, are only expected to contribute 6% of their assets towards the cost of college. While this might sound backward for some families, these are the percentages that college financial aid offices use when determining the amount of aid to award a student each year.

2. 529 College Savings Plans Are Considered a Parent’s Asset
Now that you understand the danger of holding funds in your child’s name, 529 college plans seem even more useful. Since a 529 is your asset, not your child’s, it doesn’t hurt your kid’s ability to get more aid. If you invest $100 per month starting at your child’s birth and your account earns 8% interest, then your 529 could have $48,000 when your child turns 18. If you had put that money in an account in your kid’s name, financial aid would be a lot harder to get. Since it’s in your name, you’ll have more access to assistance.

3. Grandparents Should Give Money to the Parents Instead of the Kids
Many grandparents who are in a position to help want to give as much cash as they can to their grandchildren. It’s admirable, but cutting the parents out of the equations is a monetary risk.

If a grandparent (i.e. your parent) opens a 529 plan with the grandchild (i.e. your child) as a beneficiary, then the distributions from that plan are considered part of the student’s income by the financial aid formula. Therefore, your child will face penalties that of course your parents didn’t intend. Instead, if your parents pass assets to you, then your kids can reap the benefits of their help without losing out on financial aid. Grandparents can pass on this money through the annual gift tax exemption of $13,000.

Final Word

You might not put a 529 plan ahead of saving for your retirement on your priority list, but if there’s one thing that you do for your children, do this! Your kids won’t thank you at age ten, but they will thank you after graduation when they realize they have a fresh start with little or no debt.

Don’t forget, you can hedge some of your risk by splitting your contributions between a college savings plan and a prepaid plan. You might cut into your possible returns if the economy does well, but you’ll also protect yourself from the dangers of falling returns and underfunded state accounts. Do your homework, and find the best plan, investment choices, and contribution levels that are right for you. Research the different programs that states have to offer, and make an informed decision.

When did you start investing in a 529 plan, and which type did you choose? If you’ve had a kid go through college already, what success or trouble did you find in finally applying the funds in your 529 savings?

(photo credit: Shutterstock)

Kira Botkin
Kira is a longtime blogger and serial entrepreneur who enjoys gardening, garage sales, and finding stray animals. She lives in Columbus, Ohio, where football is a distinct season, and by day runs a research study for people with multiple sclerosis. She hopes that the MoneyCrashers team can help you achieve your goals and live a great life.

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  • http://madsaver.com Mac

    Heard of prepaid tuition plans, but there seems to be a lack of information out there about it. With how fast tuition rates are spiking, it would be a huge savings to pay when the kid is very young rather than waiting until the day they enter college. Kind of out of luck if they really want an out-of-state school though!

  • http://www.castocreationsjewelry.blogspot.com megscole64

    My SIL started a 529 for my son. It’s the only one he will have and it will obviously only work if he actually goes to college. We don’t plan to force him to go to college. And if he does go, he will be paying for it himself, just like my husband and I did. Going to college isn’t a right and it isn’t the be all, end all to success.

    I love school, don’t get me wrong…I’d be a professional student if I could. But I don’t think school teaches life lessons or how to get along in the real world. I will support my son but not to the detriment of our own retirement. I’d rather invest carefully and earn a better return on my money than a 529 account can offer. I think it’s kind of a lazy way to “invest” for future college funds. On the other hand I don’t exactly trust these funds any more than any other funds.

  • http://www.yourfinances101.com/blog David/Yourfinances101

    I am a contributor to a 529 here in Georgia, but my only concern is (and I guess it will be a great problerm to have) is what if my son gets a full ride somewhere and doesn’t need the money?

    Then, where are you at?

    Maybe another reader could comment?

    Thanks

    • http://madsaver.com Mac

      That would be awesome if it happened. I’m trying to get a baseball scholarship for my kid so I too will have this problem in oh, 15 years or so.

      However, here’s your answer (via Kiplingers): If one of your children is fortunate enough to win a scholarship, you’d be eligible to take a penalty-free withdrawal from her 529 account up to the amount of the award. You would, however, have to pay federal and state income tax on the earnings portion of the withdrawal. To avoid those taxes, you could name another family member as beneficiary of the plan.

      • Mark Riddix

        Great answer Mac. That is correct.

  • gina

    I wish that I could get my act together and begin 520 contributions for my kids. Unfortunately, still trying to get out of debt–so these are on hold until I am a bit more financially stable.

  • Winston

    Good to know that there are many methods people can use to save money to help pay for their kids’ education. Sadly, my dad told me years ago that I would be on my own when it comes to college expenses. Fortunately, I managed to earn enough scholarships that I literally attend my college for free. In the future, I will probably not save any money for my kids’ education because I trust in their ability to win enough scholarships that the only thing they have to pay is their living expenses.

  • Nate Hall

    Good explanation on saving for a 529 plan. If you are sure the child will go to college, a 529 is a great way to save that money.

    I thought it was important that you pointed out the rising cost of college. Some don’t think about this, but costs will rise every year and it’s important to implement this fact into the savings plan.

    Thanks!

    • Hank Coleman

      Nate,

      You make a great point. The cost of college tuition, room, and board is rising faster than inflation. One thing that my wife and I did to combat that was to purchase a pre-paid 529 Plan for one of our sons. The other has a traditional 529 College Savings Plan invested in mutual funds, but we are pre-paying tuition for the other one locking in today’s low rates. While we do not receive interest per say, we are essentially earning the rate of inflation of tuition which is much greater than regular CPI.

  • Ron Hallmark

    I have an 18 year-old about to enter college in the fall and I have a 6 year-old entering first grade. I am saving for both kid’s college through a 529 plan established at work. Can I switch funds in my daughter’s account to my son’s account to help with the immediate costs associated with my son’s education? Both accounts are through John Hancock and I receive only one statement, but each has its own individual account number.

    • Kira Botkin

      Yes, that should be doable. Contact John Hancock – they should be able to transfer them without much of a problem.

  • http://newamsterdamlife.com/college_first.php James

    It’s a problem we would like to have, but parents concerned with “over-saving” should consider juvenile life insurance. Whether it be from their child earning a scholarship, their child not attending college, or simply high annual contributions, paying income tax rates and a 10% penalty with a 529 is an unappealing prospect.

    The College First Plan, an indexed universal juvenile life insurance contract exemplifies some of the key benefits of using juvenile life insurance for college. Withdrawals and loans from the account are accessible at any time, can be used for any purpose, and are not subject to penalty or income tax if structured correctly. The plan provides a minimum growth guarantee of 2%, funds do not negatively affect federal financial aid awards, the entire account value is protected from creditors in the majority of states, and the child will have permanent fully paid insurance for life.

    The obvious downside is that the Insurance isn’t free and will therefore reduce performance. The ‘drag’ is however minimal because the insurance is secured on the child – costs are the lowest they will ever be. The minimum growth, flexible access to funds, no penalty for non-qualified expenses, and the fact that it will not reduce a federal financial aid award, may still make juvenile life insurance an attractive alternative for parents or grandparents looking to save for college. If you include lifetime insurance that the child will never have to pay for then juvenile life insurance is certainly worth consideration.

    James Garfinkel
    CEO, New Amsterdam Life

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