Starting to save for your child's education, whether in a savings account or in special tax-advantaged investment accounts like a 529 plan, is a complicated decision. Often, saving is done before you really have the cash to do so. We'll help you figure it out by explaining all the perks you can get from your state and local governments and how to fit college savings into your budget.
Understand the basics of 529 plans
You can open a 529 plan college savings account in any state with as little as a penny. It works similarly to a 401(K) retirement account in that you are offered a range of investment options from savings accounts to mutual funds. To make investing easier, you can select an age-based plan where your investments get more conservative, leaning towards lower-risk interest bearing instruments versus higher-risk investments like stocks. This strategy allows for potentially higher earnings but higher risk options when your child is younger, and then the safety of more secure investments such as savings accounts and other lower risk investments as your child gets ready to go to college. The investments you make grow free from federal income tax.
Save based on your budget, not someone else's
It's easy to look at the rising cost of college and start scrimping every penny you can from your everyday budget. The problem that happens is you lose out on emergency savings this way. And if you have to withdraw funds you couldn't afford, you get penalized with a 10% tax penalty from the IRS plus any tax you would have paid on the earnings. (See also: Here's Why You Really Need an Emergency Fund)
Let your state and your family help you save for your child's education
There are several ways you can get extra money for your child's college education beyond what you can personally afford to contribute. You can let family know you'd like them to donate to your child's education instead of other gifts, you can participate in a free online shopping rewards program: Upromise.com, or you can get money from your state. (See also: Is Free College Really Free?)
Your state may offer four kinds of help:
- State income tax deductions
- Matching grant programs similar to a 401(k) matching program for retirement
- Scholarships through the 529 plan itself
- State income tax deduction or credit. States offer state income tax deductions for 529 plan contributions up to $5,000 per child or other beneficiary, per tax filer, and per year. Thus, a couple could contribute up to $10,000 annually. The catch is you may only get the tax deduction if you pick the plan your state offers. While you can choose from nearly any 529 plan in the country, your state can make a choice as to whether they offer you a deduction or credit for the contribution. You can find out if your state offers a tax benefit by looking at your state's taxation website.
Figure out what your goal is
If your goal is to just save as much as you can, a traditional 529 plan is a great idea. It works similarly to saving in a 401(k) plan in that the growth is just from your contributions and investment growth. If your goal is to pay for a set number of semesters, you may want to choose a prepaid tuition plan. These plans are available in less than a dozen states and offer you the chance to buy future tuition at today's tuition prices. You don't have to have all the money at one because payment plans are available. Just think of it like a car loan, because you are committing to a long-term monthly payment. If you want your child to attend a private college, the Private College 529 Plan is available to residents in all 50 states. You most likely will not receive state tax benefits with this plan, and you want to be fairly committed that your child will go to a private college.
Starting to save for college is a complicated decision. Do so with your own budget in mind and let others help you, whether it's your parents, your state or an online rewards program.