What is a 529 College Savings Plan?

What is a 529 College Savings Plan? April 12, 2012

Back in 1996, Congress created what we know today as a 529 College Savings Account.  In short, a 529 plan is like a retirement account, but for college.

You see, with a 529 college savings plan, your contributions grow tax free and can be distributed tax free for qualified college expenses.  Pretty nice, huh?  Well it gets better because some states will even allow you to deduct some or all of the contribution from your state taxes.

We’ll talk about the tax benefits later, but first let’s look at how a 529 plan works and what you should know about them.

Types of 529 College Savings Plans

Wait, there’s more than one type?  Each state 529 plan can provide two basic types of accounts: 529 Prepaid Tuition Plan and a 529 Savings Option.  But it doesn’t automatically mean that your state will offer both types, so be sure to check.

The nice thing is that you can compare 529 plans by state, in order to find the best plan for you.  Many plans allow non-residents to open accounts, so don’t be afraid to look at other state 529 plans too.

Prepaid Tuition Option

This is just like it sounds – you can lock in today’s tuition rates for your child’s education tomorrow.  Many state plans allow you to prepay all at once or over a period of equal payments.  With tuition increasing at an average of 8% per year, this isn’t a bad option at all!  In fact, I’d consider an 8% return a great investment, which is why I think the 529 prepaid tuition option is awesome.

529 Savings Option

If you would rather have your contributions grow through investments, you can choose to make contributions into a 529 investment account.  These are much more common and they allow you to make regular contributions into the account.

The purpose of the account is to give your dollars the chance to grow tax-free so that you can meet the rising cost of education for your future college student.  States that offer the 529 savings option generally don’t require state residency to participate.

529 College Savings Plan Tax Benefits

Before you sign up with the first 529 plan you see, be sure to check with your home state first.  Contributions may be deductible in your state, so you’ll want to find out if your state gives you such a tax break. Most states, however, will put a limit on the amount you can deduct from your state taxes, so make sure you understand your state’s rules.

Earnings are Tax Exempt

One of the best features of a 529 college savings account is that the earnings within your account can be exempt from taxes as long as you use it for qualified educational expenses.  Normally, you would have to pay taxes on your investments like with a brokerage account, but with a 529 plan, the investor can get a tax break on the contributions as well as the distributions.

Income Eligibility for 529 Plans

529 College savings accounts do not have an income limit when it comes to eligibility.  In other words, anyone can open a 529 college savings account regardless of how much they make.

You are limited, however, on how much you can contribute.  Depending on your state, you may be able to contribute up to $300,000 but you’ll want to check the plan rules for your 529 plan.

Using the Money for Qualified Expenses

Since most states do not place an age restriction or time frame on using the funds, you can allow the money to grow until the student is ready to attend college.  In fact, if the student wants to wait until age 40, the money can stay and grow tax-free while they wait to attend college

If something happens to the beneficiary of the account, a new beneficiary can be selected to use the funds as long as they are in the same family of the first beneficiary.  The IRS considers family to be “the original beneficiary’s spouse, children, sisters, brothers, nephews, nieces, first cousins, and any spouses of those persons.”

When it comes to actually using the money for college expenses, you can use the funds to pay for tuition at any accredited degree-granting educational institution.  This includes public, private, and both 2-year and 4-year colleges.  Even more, your state may allow you to use the funds for books, room and board, transportation and even computers.

Opening a 529 Plan

It’s important to know that you can only have one beneficiary per account.  That means if you have four children, you will need to open four accounts – one for each child.

You will be the account holder and the student will be the beneficiary.  The money within the account belongs to the account holder, so you don’t have to be afraid of the student running off to Europe with the saving intended for their education.

In addition, other people can make contributions into your student’s 529-college savings plan, though a tax break may not apply to them.  For example, the student’s grandparents can contribute every year around the student’s birthday – what better gift can you think of!

Investing Your 529 College Savings Account

Since most states use familiar investing companies like Vanguard, Fidelity, and TIAA-CREF, you can be confident that your selection of investments will be top notch.  You have the freedom to select your investment option, but many plans limit the number of times you can change your investment.  Some have restrictions that keep you from changing your investment option at all.

If you are unhappy with the investment performance and wish to move your 529 account, you can roll your money into another state’s plan once every 12 months.

The most common investment option within 529 plans is the age-based investment or target date strategies.  With these strategies, your investment is based on the age of your student.  As they get older, the investment will gradually become more conservative.  The account is most conservative as the student reaches college age.

Understanding the Fee Structure

Investment firms charge fees in order for you to use their mutual funds and investment options.  You should try to look for a plan that gives you the biggest tax breaks as well as investment with the smallest fees.  These common costs are often associated with 529 plans:

  • One time enrollment fee to open 529 account
  • Annual maintenance fee
  • Mutual fund fee – expense ratio

For most plans, the fees to manage your college savings will be in the range of 0.3% to 2% or more.

Before You Start Saving

Before you open your account and throw money at a 529 plan, make sure you look at your entire financial picture.  How much time do you have before your child attends college?  What is your current disposable income?  What debts are you trying to eliminate?  What is your tax situation and how will a 529 help?

If you have the ability to work with a certified financial planner, make sure you ask their opinion about which plan works best for you.

A 529 college savings account really is a great tool to build up your savings.  If you haven’t considered its benefits, take a look at your state’s 529 plan today.

How is your family saving for college expenses?

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