If you are looking for a wise investment for your family’s future, saving for college is a smart place to start.
Although there are various options, a 529 college savings plan gets high marks for its tax benefits and flexibility. And since it’s an investment, the sooner you start saving, the more you’ll have when you need it.
There are two types of 529 plans: savings and prepaid tuition. Savings plans are available in most states, while the prepaid plans are less common.
The biggest benefits of these state- or school-operated ‘qualified tuition programs’ are:
- The earnings are tax free if used for qualified higher education expenses.
- The funds are controlled by the person who opened the account until they are withdrawn.
- Significant contributions can be made by you, family members or friends.
- And these plans can be set up for your children, grandchildren … even for yourself.
So what’s the difference between a savings and prepaid tuition plan?
Think of the savings plan as an investment, with your earnings based on the performance of the stock market. The 529 savings options are a lot like mutual funds, with the offerings usually being a mix of stocks and bonds, and they are likely to be offered with choices at various levels of risk – from aggressive to conservative.
These plans – which generally earn more money than traditional savings accounts like money markets or CD’s – are offered by most states. The money and its earnings can be used for both undergraduate and graduate costs – including tuition, room and board, even computers and peripheral equipment – at any accredited college or university.
A benefit of this type of plan is that you can invest one state’s plan and send your child to a school in a different state. And, if you like, you can move your money once a year into a plan that might be more attractive in another state.
You can invest in any state’s 529 savings plan and your earnings are not subject to federal income taxes when used for qualified education costs. While the actual contributions are not deductible on your federal taxes, some states do allow this type of deduction.
These plans allow you to pay money now to lock in future college costs, but they are less widely available than the 529 savings plans.
Depending on the type of prepaid plan, the money you pay usually allows you to cover in-state tuition costs, although some plans might cover other expenses as well. And most prepaid plans have age or grade limits for the beneficiary.
Since these plans are usually targeted at the schools offering them, make sure you check to see what your money-transfer options would be if your child or beneficiary chooses a different school to attend.
An advantage of this type of plan is that your payments lock in future college costs and the plan must make good on its promise.
Things to keep in mind:
While 529 college plans are attractive because their earnings are tax-free when the money is used for qualified education expenses, another big benefit is that large amounts of money can be deposited for the beneficiary – in excess of $300,000 for some plans.
Contributions under $14,000 annually fall under the federal gift tax exclusion and a lump-sum deposit of up to $70,000 can be spread out over five years and still qualify. To make saving easier, automatic transfers can also be set up from your checking or savings accounts.
The plans are also professionally managed, but you’ll want to check on any fees associated with the plan you choose.
There also are other considerations to be aware of.
If the money in the plan isn’t used for qualified education expenses, you face a 10% withdrawal penalty on the earnings (not the principal), and the withdrawn earnings will also be taxed at your regular income tax rate.
However, if your child decides not to attend school, the person who controls the account could name another beneficiary for the money and it could be used for that new person’s qualified educational costs.
The money in a 529 account will have some effect on financial aid applications. Be sure to check with an advisor on how this is affected by federal or school rules.
And as part of any financial planning, make sure to do your research on the options you have, and check with a trusted financial advisor on the various plans’ options and risk levels.