Most parents want their children to get the best higher education possible, but that dream comes with a high price tag. Tuition and fees for one year at a four-year, private non-profit college now average
$34,740 at public four-year institutions, that figure is $9,970 . Those sums have more than doubled in the past 30 years, adjusted for inflation.
The growing costs of college means parents increasingly need to plan ahead for financing their kids’ educational dreams. One way to save for college tuition is through a 529 college savings plan, named for the relevant section of the federal tax code. What is a 529 college savings plan?
Also known as a “qualified tuition plan ,” this is a type of tax-advantaged account that allows savings to grow through investment and funds may only be withdrawn for certain educational expenses.
While 529 plans have been around for more than 20 years, many parents still aren’t sure how they work. Less than one-third of Americans report even knowing what these accounts are for.
Yet 529 plans can be an effective way to save for your child’s education while taking advantage of tax benefits. Here’s what you need to know about how 529 plans work and whether opening one is the right move for you.
529 Plan Basics
There are two kinds of 529 plans, and every state offers at least one. The first is called a prepaid tuition plan, which allows you to buy credits at certain colleges and universities at today’s prices to be used for tuition and fees in the future. Such plans are usually available only at public schools and for in-state students.
The benefit of this plan is that you could save big on the price of college by prepaying before the prices possibly go up. The risk is that your child may not attend a participating institution, meaning the plan may only produce a small return.
Also, if your state government doesn’t guarantee the plan, you may lose the payments you’ve made if the state runs into budget shortfalls. Keep in mind that prepaid tuition plans often charge fees for enrolling and ongoing maintenance.
The second type of 529 plan is an educational savings plan. Here’s how it works:
Contributions are flexible, meaning you can save monthly, quarterly, annually, or deposit a lump sum. Beyond parents making regular payments, 529 plans can be a clever way for the extended family to give a meaningful gift on birthdays or holidays.
Lots of states provide tax benefits for saving in a 529 plan, such as deducting contributions from state income taxes or giving matching grants. Check your local tax laws to see if you qualify.
Investing your Funds
Once you make contributions, a possible next step is to invest your funds. You will likely have a range of investment options to choose from, including mutual funds and exchange-traded funds (ETFs), which vary from state to state.
You may want to tailor your choices to the date you expect to withdraw the funds—you can possibly be more aggressive if you have a longer timeline, but may sway more conservative if you only have a few years. One option is to choose a target-date fund, which would automatically adjust your portfolio to become more conservative as your child’s college years approach.
That usually means a greater share of stocks initially and more bonds and cash over time. You may want to think about whether you’ll want to use the money earlier for elementary or secondary education when setting targets.
Money can be withdrawn tax-free from a 529 plan to pay for any “qualified educational expense.” This includes tuition, fees, books, supplies, certain computer technology and services, and room and board.
You can make withdrawals as long as your child is enrolled at least half-time at an accredited school, regardless of where in the U.S. it’s located, and occasionally abroad. Starting in 2018 , parents can also withdraw up to $10,000 a year to pay for tuition at any K-12 public, private, or religious school.
If you withdraw money for the above expenses, you won’t have to pay federal income tax, and often state income tax, on your earnings. If you withdraw the funds for other reasons, you’ll have to pay taxes, as well as a 10% federal tax penalty on the earnings.
There are some exceptions on the penalty—you won’t need to pay it if the beneficiary gets a scholarship, enrolls in a U.S. military academy, or dies. However, taxes would still need to be paid on the earnings in these scenarios. It is possible to change the beneficiary of a 529 plan if the original one no longer needs it. For example, you can switch to a younger child if your eldest got a scholarship.
How 529 Plans Compare to Other Options
Compared to other methods of saving for college, 529 plans offer certain benefits. By investing the funds, this account gives your money the chance to grow over time. If you just leave your savings in cash or even a high-interest savings account, you may actually be losing money as the years go by, since it likely won’t keep up with inflation.
The 529 plan also has advantages when it comes to calculating financial aid. When you fill out the Free Application for Federal Student Aid (FAFSA®) , the account is considered an asset. However, if the parent owns it, only up to 5.64% of the amount saved counts when the government calculates the “expected family contribution,” resulting in a higher financial aid package. (If the student owns the plan, up to 20% of the savings can count in the calculation.)
The bottom line is that while a 529 plan may slightly reduce available financial aid, it will likely save much more overall by reducing the amount of loans you or child need to take out.
If you put your college savings in a Roth IRA instead, that won’t be counted as a parental asset on the FAFSA since it’s a retirement account. However, the 529 plan comes with more tax benefits. Specifically, you can withdraw both contributions and earnings anytime from a 529 plan without paying taxes or penalties, as long as it’s for qualified educational expenses.
With a Roth IRA, you can withdraw your contributions at any time, also without taxes or penalties. However, if you’re under age 59 ½, you would pay income tax and a 10% penalty tax for withdrawing investment earnings.
Additionally, some 529 savings plan allow you to deduct contributions on your state income taxes, while any contributions to Roth IRA accounts are with after-tax dollars.
Choosing a 529 Savings Plan
Every state offers a 529 savings plan, but not all are created equal. When trying to find the best 529 college savings plan, you may want to think about the tax benefits and the fees.
First, you may want to understand whether you qualify for a state income tax deduction or credit for your contributions, based on your state of residence and the plan. Check your state laws and consult a tax professional to learn more about your particular situation.
Some states, such as New York , only offer deductions to in-state taxpayers who use their plan. Other states, including Pennsylvania , allow residents to take a deduction regardless of which state’s plan they use.
The next thing you could consider are the fees associated with your plan, which could include enrollment fees, annual maintenance fees, asset management fees, and more. Some states let you save on fees if you have a large balance, contribute automatically, are a state resident, or opt for electronic-only documents.
Looking for another option to pay for your child’s education? A parent student loan could be a solution for you. SoFi offers private parent student loans that offer competitive rates and no fees to help you pay the way for your child’s schooling. Plus, SoFi offers two different repayment options to work with you and your budget.
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