How to Prepare for Your Child’s Future College Education

The rising cost of higher education has made saving for college one of the biggest concerns for many parents. Saving – whether started early on or just a couple years before college – is more important than ever before. Opening a 529 savings plan can be a great way to take advantage of tax benefits while building a college fund. However, many people don’t know what a 529 is or how it works. Learn more about this tax-advantaged savings plan to see if it’s the right option for you and your child.

What is a 529 Plan?

Named for section 529 of the Internal Revenue Code, a 529 savings plan is an investment account sponsored by states to pay for college and other higher education expenses. There are several reasons people choose a 529 over other savings plans, but its primary appeal is tax-free compounding. The investment earnings in the account grow tax-free, and when you withdraw to pay for a qualified expense, you won’t be taxed then either. And the longer you hold the money in the account, the greater the benefits. “529 plans give you tax-free income growth when the future withdrawals are used for qualified expenses,” explains Scott W. Johnson, owner of WholeVsTermLifeInsurance.com. Scott spends a lot of time explaining to his clients that there are better ways to prepare for college than a whole life insurance plan. “If you invest early, 529 plans may allow you to put in just 25 percent of the cost of education and yet have the whole thing paid for.”

How the Tax Reform will affect 529s

Under the new law, 529 savings can be used towards elementary, high school or homeschool expenses. Families will be allowed to withdraw up too $10,000 per year, tax-free. This is a benefit for parents who want to homeschool their child or enroll them in a private or religious school for K-12. While this sounds like a win, Forbes cautions there are things to consider before withdrawing funds to pay for K-12 education.

Who Needs a 529?

Anyone interested in building a college fund can open a 529 – parents, students, grandparents, friends or other relatives, and even charitable organizations. However, that doesn’t necessarily mean a 529 is needed. There are several ways to save for a college education and the right type of plan really depends on the beneficiary’s and/or account owner’s needs. A Roth IRA, for instance, is beneficial because it can also function as a retirement savings account, which means the investor can repurpose this money should their child decide not to go to college. 529s also vary from state-to-state, which may make other plans more appealing.

How Does It Work?

529 plans come in two forms – savings plans and prepaid tuition plans. States administer 529 plans, which means the options and incentives offered can vary across borders. Prepaid tuition plans are generally less common, but this type of plan allows you to make an up-front payment for the cost of attending an in-state public college at the current tuition rate. This can be an ideal option if the cost of tuition is expected to rise by the time the beneficiary attends college. By contributing to a prepaid 529, the investor purchased tuition at a discounted rate.

If an investor is interested in opening a 529 savings plan, they will need to review and understand the benefits their state provides. “I suggest that most people look at savingforcollege.com to determine if there is indeed a need for you to use your own state’s 529 plan – for many states there is no advantage,” says Johnson. However, since some states do offer benefits for residents – for example, contribution matching for individuals under a certain level of income – it’s important for parents to be aware of all options before making a decision.

529 Plans vs. Other Ways to Prepare for College

A 529 plan might be perfect for one family or student but it might not be the best option for another. To help you make an informed decision, here’s an overview of other common ways parents can start building their child’s college fund:

Benefits of 529 Plans

According to Johnson, 529 plans are often the best option for the average parent looking to save for college. The following are some of the benefits parents can expect to receive if they choose to open a 529 savings plan:

Ability to change designated beneficiary

With a 529, it’s easy and to change the designated beneficiary, and there aren’t any tax consequences for doing so. “I like that if one doesn’t go to college, or doesn’t need the money, I can move the money for qualified expenses to another beneficiary,” says Dr. David Schein, who contributes to his three grandchildren’s 529 plans. This mobility can be ideal for parents with multiple children.

You can use an out-of-state 529

One of the common myths about the 529 is that an investor is stuck with the plan available in their home state. This isn’t the case at all. In-state residents usually qualify for certain benefits, but sometimes utilizing an out-of-state plan is the best and is indeed an option. “I live in Texas now,” says Schein, “which does not have an income tax, but I continue to contribute to the Virginia 529 plans for my first two grandchildren. For my third grandchild, my son in Maryland set up the 529, but also set it up in the Virginia plan since his research indicated that it was a strong plan.”

Greater account control

Some parents want to maintain control over the savings account to ensure funds are used as intended. With a 529, parents can do just that because unlike other savings plans – such as the UGMA/UTMA – the child doesn’t take over the account once they hit a certain age.

Tax-free earnings

Investment earnings aren’t subject to federal tax, and in most cases state tax, if used towards qualified education expenses.

Tax-free withdrawals

Schein said one of the reasons he prefers a 529 over other savings plans is because it offers tax-free withdrawals. So long as withdrawals go towards qualified academic resources – which now includes computer equipment – the investor won’t be taxed for accessing the funds.

Tax breaks and credits

More than 30 states also offer a tax deduction or credit for 529 contributions, up to the state’s limit. To find out if your state offers a deduction or credit, or to find out how much you could benefit from one, try using Vanguard’s 529 state tax deduction calculator.

Age-based investment options

Most 529s offer age-based investment options, meaning the asset allocation automatically adjusts over time. With this option, your 529 investments start out aggressive and switch to more conservative fixed income options as your child gets older and closer to the start of college.

Disadvantages to Consider

Despite the above benefits, 529s do have some disadvantages to consider, and it’s important to weigh the pros and cons before opening an account. Below are some of the drawbacks of utilizing this savings plan:

Non-deductible contributions

Although 529s offer many tax advantages, deductible contributions is not one of them. Any contribution you make to the 529 cannot be deducted from federal taxes, but, as mentioned above, certain states may offer tax deductions or credits.

Fees

While specific fees vary between different types of 529 plans, many have been known to charge account management fees that should be taken into account when considering a plan’s overall usefulness.

Non-academic withdrawals can be taxed

If funds are withdrawn and used for anything that isn’t a qualified education expense, the withdrawal will be taxed. If you only have one child, this is something to keep in mind. If your child doesn’t go to college and you don’t change the designated beneficiary to a prospective college student, any withdrawal will be taxed at a 10% federal penalty because the money won’t be used for a qualified education expense.

Limited usefulness of prepaid tuition

While Schein states that, “A prepaid tuition plan is great for someone that has enough funds to do so,” students may not be able to maximize their funding benefits if they decide to attend an out-of-state school. “Instead,” Schein says, “I contributed to the savings plan, which is very flexible.”

FAQs

How to Open A 529

Forbes reported the main reason people don’t open 529 accounts is because they don’t know how to. But opening an account is surprisingly simple. Here’s how:

Expert Tips to Maximize Your Savings

529 plans are a great way to reduce taxes and avoid penalties, but that’s only if you understand and follow all the rules from the start. Here are some expert tips to help you maximize your 529 savings: