For many parents these days, saving for their child’s college education seems like a necessity. Financial aid and scholarships rarely cover 100% of the cost of higher education, and with the price of a college education rising along with awareness of the burden of student loans, some parents consider saving for their child’s college a part of their monthly budget.
Of course, not every parent has the means to help cover the cost of their child’s education. But for those who do, it’s never too early — or too late — to start. Whether you have five years to save or 15, when you’re ready to start, take a look at 529 savings plans. Investing in a 529 plan is one of the most efficient ways to save for your kids’ college costs.
What Is a 529 College Savings Plan?
These plans get their name from the section of the IRS code that authorizes this type of college savings vehicle: IRC Section 529. Essentially, a 529 plan is a tax-advantaged investment account designed specifically for tuition and other related educational costs.
A 529 plan offers a variety of federal and state tax benefits:
- The earnings in the account are not subject to federal or state income taxes, so the investments can grow tax-free.
- As long as your child uses the funds for qualified education expenses, distributions are not subject to federal or state income taxes.
- Many states offer some form of state income tax deduction or credit for contributions made to a 529 plan. Typically, the state tax break requires contributing to an in-state plan. However, if you don’t mind missing your state’s tax benefits, you have the option to invest in another state’s program if its investment options and fee structure are more appealing.
You may be able to enroll in a 529 plan managed by your state, a university, or through a financial institution. Because the tax benefits vary by state, talk with your accountant or compare state incentives at FinAid.org.
Types of 529 Plans
There are generally two types of 529 plans:
1. 529 Savings Plans
The 529 Savings Plan is a more traditional way to save for college. You save money in the account, invest the funds based on your investment goals and risk tolerance, and use the money you accumulate for expenses at any college nationwide.
The money you or your child has available to pay for their education depends on how much you save and how your investments perform. Most 529 plans offer a limited menu of mutual funds, although a few allow account owners to invest in equity-indexed annuities, certificates of deposit, and other types of investments.
2. Prepaid Tuition Plans
Prepaid tuition plans are savings plans that allow you to pay for future tuition at today’s rates. Under a prepaid plan, you make fixed payments for a set time period and the state locks in the cost of tuition when your child attends college.
Prepaid tuition plans typically cover tuition and mandatory fees only. However, some plans allow you to purchase room and board or use excess tuition credits for other qualified expenses.
The main drawback of selecting a prepaid tuition plan is that they’re usually tied to your in-state school. If your child decides to attend an out-of-state college, you won’t get the benefit of guaranteed tuition. Instead, most plans pay an amount equal to the tuition and fees at your state’s public institution, and you’ll have to cover any additional costs out of pocket or through financial aid.
Advantages of 529 Plans
1. Income Tax Breaks
Although contributions to a 529 plan aren’t deductible on your federal income tax return, the earnings in the plan grow tax-free. Plus, as long as you use the money to pay for qualified education expenses, the money won’t be taxed when you withdraw it, either. You don’t even have to report 529 plan contributions on your federal tax return.
Many states offer tax breaks for 529 plan contributions as well.
2. Parents Maintain Control Over the Account
For the most part, the child named as a beneficiary of the 529 account has no legal right to the funds, so parents can rest assured the money will be used for its intended purpose.
This differs from UGMA and UTMA custodial accounts, where the child takes control of the assets once they reach legal age and can spend the money however they choose.
A 529 plan can be a very low maintenance way to save for college. Most plans provide an option to invest in age-based portfolios that automatically shift toward more conservative investments as your child gets closer to college age. Plus, many plans allow account owners to set up automatic contributions by linking their bank account.
4. Widely Available
Many tax-advantaged accounts, such as Roth IRAs and Coverdell Education Savings Accounts, have income limits, age limits, and low annual contribution limits. But 529 plans are available to anyone regardless of income or age.
Some states set lifetime contribution limits, but they are relatively high. They range anywhere from $200,000 to more than $500,000.
Keep in mind that the IRS treats 529 plan contributions as gifts for tax purposes. For 2020, that means you can contribute up to $15,000 per year without having to file a gift tax return with the IRS.
Disadvantages of 529 Plans
1. Tied to Tuition
If you put your money into a 529 savings plan, that money must be used for qualified education costs.
Until recently, the funds in a 529 plan could only be used for higher education. Thanks to the Tax Cuts and Jobs Act of 2017, parents can now use up to $10,000 per year of 529 plan funds to cover elementary or secondary school tuition costs.
If you use the money for another purpose, you’ll have to pay taxes on the amount you withdraw from the plan, as well as a 10% penalty. That can be a big problem if your child decides they don’t want to attend college.
There are a couple of ways to handle the money in your account if your child decides they don’t want to go to college:
- Leave the Account Alone. There’s no time limit for taking withdrawals, so you can keep the money in the account in case your child decides to go to school later.
- Change Beneficiaries. You can switch the beneficiary of the 529 plan from your child to another eligible family member, such as a spouse, sibling, niece, nephew, or grandchild.
- Bite the Bullet. You can always withdraw the money and deal with the tax hit. The good news is you’ll only pay taxes and penalties on the earnings portion of your withdrawal if you go this route — you won’t have to pay federal income taxes on your original contributions to the plan.
If your child doesn’t need the money in a 529 plan because they receive a scholarship, you can withdraw the amount of the award from the plan without paying the 10% penalty, although you will have to pay income taxes on the earnings.
In a sense, your money is “locked in” when you save for college using a 529 plan. So while saving is smart, don’t overdo it.
2. Risky Business
Like any investment, there are fees and risks involved in saving with a 529 plan. When selecting a plan, be sure to ask about fees and weigh your state’s tax benefits against the cost of investing in that plan. If you shop around, you may be able to save more than you’d get from state tax breaks simply by choosing a program with lower fees.
You also need to consider the volatility inherent in any investment. If the market falls right when you need the cash, you could end up with a lot less money than you were counting on. To protect against this risk, many 529 plans offer age-based investment portfolios. These portfolios automatically adjust your investments based on your child’s age. When your child is young, you might be invested in riskier investments, such as stocks. As your child gets closer to college age, the investments shift to more conservative options, such as bonds and money market funds.
3. No Guarantees
Believe it or not, most prepaid tuition plans aren’t guaranteed. Each state plan has its fine print, and yours may explain that if the plan is underfunded for any reason, then your prepaid credits don’t really transfer. Many state plans are underfunded.
Most prepaid plans are based on the assumption the state will be able to reinvest your money and get a return that beats the rising cost of college tuition. For example, if tuition rates rise by 6% over the next decade, but the state plan can earn an 8% rate of return on its investments, your prepaid plan may be fine. However, if tuition rates rise by 10% and the plan earns an 8% return on investment, the plan could terminate at any time, leaving you high and dry.
For this reason, many states have exited the prepaid tuition business. Only a handful of states still offer prepaid tuition plans, and fewer still guarantee their prepaid plans. Be sure to read the fine print before you invest.
4. Not the Only Option
Although 529 plans have advantages, you may want to consider other investment options that don’t have the tuition-only restriction.
For example, if you’re in your 40s and have a young child, the age at which you could begin withdrawing funds from a Roth IRA, Roth 401(k), or traditional 401(k) might coincide with the time when your child will be ready for college. By contributing funds intended for college savings into a retirement account, you could get some significant 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 need to consider the advantages and drawbacks of different strategies when it comes to qualifying for financial assistance. Focus on these three issues:
Children’s Assets Count Against Them for Financial Aid
A college will look closely at the amount of assets that are in your child’s name when they apply for financial aid. Children are expected to contribute up to 20% of the 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 toward the cost of college. Although this might sound backward for some families, these are the figures college financial aid offices use when determining the amount of aid to award a student each year.
529 College Savings Plans Are Considered a Parent’s Asset
When you consider the danger of holding funds in your child’s name, 529 college plans seem even more useful. A 529 plan is your asset, not your child’s. So it doesn’t have as much of an impact on your child’s ability to qualify for financial aid.
The calculations for determining financial aid eligibility are complicated, but in general, the formulas for calculating an Expected Family Contribution (EFC) are based on 5.64% of any assets owned by the parent in a 529 plan and 20% of any assets owned by the student.
For example, say you invest $100 per month into a 529 plan starting at your child’s birth and your account earns 8% interest. By the time your child turns 18, the account would be worth $48,000. According to the EFC calculation, you would be expected to be able to put about $2,700 toward your child’s education (that’s 5.64% of $48,000).
On the other hand, if you put that money in a savings account in your kid’s name, your child would be expected to be able to contribute $9,600 to their own education (that’s 20% of $48,000). So, using a 529 plan versus a savings account results in eligibility for thousands of additional dollars in federal financial aid.
Grandparents Should Give Money to the Parents Instead of the Kids
Many grandparents want to help their grandchildren save for college. If your children’s grandparents want to help, work with them to ensure their gift doesn’t do more harm than good.
If a grandparent opens a 529 plan with a grandchild as the beneficiary, then distributions from the plan are considered part of the student’s income by the financial aid formula. Instead, ask the grandparents to pass the money on to you so that you can contribute it to a 529 plan. This allows your kids to reap the benefits of their grandparents’ generosity without losing out on financial aid.
For 2019 and 2020, grandparents can gift up to $15,000 per year, per person through the annual gift tax exemption.
Don’t put saving for college ahead of saving for your retirement. But if you have the means to help your child save for college, consider a 529 plan. Your child will thank you after graduation when they can start their adult life with little or no student loan debt.
Do your homework and find the best plan, investment choices, and contribution levels that are right for you.
Are you saving for your child’s college education? What type of plan did you choose?