Saving for college can feel like a major burden. Tuition costs continue to rise; in fact, from 2008 to 2018 the average cost of college increased 25% for private institutions and nearly 30% for public ones. Many students are also graduating with an overwhelming amount of student loan debt, which currently totals a whopping $1.57 trillion, according to the credit bureau Experian.
Using a 529 college savings plan is one way parents can save money for their children’s future college expenses while taking advantage of tax savings on the fund’s investment growth.
Find out how these plans work and how to find the best 529 college savings plan for your family.
What is a 529 plan?
A 529 college savings plan is a tax-advantaged investment account. It offers tax savings on withdrawals when the money is used for eligible education expenses. All 50 states (plus the District of Columbia) offer one or more college savings plans.
You can start saving for a child’s tuition as soon as they’re born. Compared to a standard savings account that offers an interest rate under 1%, a 529 investment account has more growth potential. Plus, you don’t have to pay any capital gains tax on those earnings, as long as you use the money for qualified education expenses for the child on the account.
529 college savings plan rules are outlined under Section 529 of the Internal Revenue Code, which authorizes the tax-free status of these plans.
The types of 529 college savings plans
There are two types of 529 savings accounts for college students to choose from: education savings plans and prepaid tuition plans.
Education savings plan
An education savings plan offers the most flexibility because your child can use the funds at any college or university for tuition, fees, and room and board. While they are sponsored by individual states, you usually don’t need to be a resident of that state in order to use the plan. You can also use up to $10,000 per year for private school tuition for both elementary and secondary schools.
Your contributions are placed in an investment account and you can choose how to invest those funds. Many states’ 529 plans provide a target-date portfolio. A fund manager controls your asset allocation based on the number of years until you plan to use the funds. As the time draws nearer, the target-date portfolio starts to shift out of riskier investments. You may also be able to craft your own portfolio using the ETFs and mutual funds available in the state-sponsored plan. The drawback with an education savings plan is that your savings are dependent on the performance of your investments.
Prepaid tuition plans
Prepaid tuition plans are typically used to save for specific in-state public schools. Instead of investing your contributions, you pre-purchase credits for a specific school or group of schools. The funds can usually only be used for tuition and fees, not room and board.
There are two risks with a prepaid tuition plan. The first is that the plan may not be guaranteed by the state, so if the sponsor goes under, you could lose all your savings. Additionally, it limits your child to the group of colleges she may attend. The reimbursement rate is low if your child ends up attending a school outside of the participating colleges in the prepaid plan.
What expenses do 529 plans cover?
One of the major benefits of a 529 plan is the variety of qualified expenses that are eligible for tax-free withdrawals. College and trade school students may use tax-free funds for qualifying expenses such as:
- Room and board
- School fees
- Books, computers, and other required materials
Additionally, parents can use up to $10,000 each year for K-12 tuition expenses. The SECURE Act of 2019 also allows students to use up to $10,000 of 529 savings to pay off their student loans.
What’s not covered by 529 plans
There are some school-related expenses that are not covered by the tax-advantaged funds in a 529 plan. Transportation to and from college along with healthcare costs are not covered, unless they’re charged by the college.
You may still use the funds for non-eligible expenses, but you’ll incur two types of tax penalties. The first is that you’ll have to pay income tax on any earnings (though not your original contribution amount) you use on non-qualified expenses. On top of that, you’ll be charged a 10% penalty fee on those distributions.
Who can open a 529 plan account?
Anyone may open a 529 college savings plan on behalf of a beneficiary. This includes parents, grandparents, friends and relatives. In fact, you can even open an account before your child is born, then transfer the beneficiary status to your child once she has a name and social security number. You can also open a 529 account for older children.
There is, however, some different treatment of the plan funds depending on who owns the account. The most common scenario is a parent (or parents) who open and own the account. When it comes time for your student to fill out the Free Application for Federal Student Aid (FAFSA), the 529 plan funds can lower the amount of need-based aid the child receives.
On the other hand, if a grandparent owns the account with the child as the beneficiary, you run into a different issue. The 529 funds don’t count on the FAFSA, but any distributions do count as income for the student. This has tax implications and must be reported on the FAFSA the following year, which can reduce federal aid.
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