How Can a 529 Plan Help You Save for College?

How Can a 529 Plan Help You Save for College? article image.

Many parents believe a college education is essential to their child's success. Getting that diploma doesn't come cheap, however, and it's getting more expensive every year.

The average annual tuition and fees for in-state students at a public four-year college is $9,410 (or $37,640 for four years), according to College Board. For a private four-year college, average annual tuition and fees are $32,410 per year (or $129,640 for four years). And that doesn't even include the cost of room and board, books and all the other expenses of college life.

Forecast 18 years into the future (if you're a new parent), and the idea of paying for college can be overwhelming. Fortunately, a 529 plan can help ease the stress. A 529 plan is a tax-advantaged investment account that can be used to pay for qualifying educational costs, including K-12 tuition, college and postgraduate education.

How Does a 529 Savings Plan Work?

First created in 1996, 529 plans are designed to make it easier to save for college and postgraduate education. Since 2018, when the Tax Cuts and Jobs Act of 2017 expanded their uses to include paying for K-12 tuition, they've also been a way to help finance pre-college education costs.

The plans may be offered by your state or by schools, and you can find at least one type of 529 plan in each state. If you choose a state-sponsored plan, make sure the beneficiary isn't limited to attending school in that state. You can select a 529 plan outside your state, but if your state provides tax breaks for investing in its 529 plans, choosing an out-of-state plan could leave tax benefits on the table.

Here's how it works: The person who starts the 529 savings plan (the account owner or plan owner) establishes the plan for a chosen beneficiary. The beneficiary is usually a child or grandchild, but it can be another family member or even someone who's not a family member. The plan's owner controls the money in the plan and makes decisions about investing and withdrawing it, even after the beneficiary reaches age 18. If the original beneficiary decides not to go to college, the account holder can transfer the 529 plan to another beneficiary.

Similar to mutual funds, most 529 plans offer a variety of investment options from which the plan holder can choose based on level of risk. Many use an age-based investment strategy that invests in higher-risk options (such as stocks) during the beneficiary's early years and then switches to a lower-risk asset allocation once the beneficiary is 12 and older. You should always read the prospectus for any 529 plan you're considering to make sure you understand your choices, know the risks, and understand how plan management fees will affect your results.

You can start a 529 plan with a lump sum contribution or set up regular monthly contributions. More than one person can contribute to a 529 plan. For example, you might set up a 529 plan for your child and invite other family members to contribute to it if they like. Some 529 plans allow contributions of as little as $10, offering a nice way to allow grandparents and other relatives to give a young relative a meaningful gift.

What Are the Types of 529 Plans?

There are two types of 529 plans: education savings plans and prepaid tuition plans. Here's how they differ:

  • An education savings plan or college savings plan allows you to save for tuition and related education expenses at any qualified college or university, including postgraduate education such as getting a Ph.D. or MBA. You can also use up to $10,000 annually for K-12 school tuition. This is the best-known type of 529 plan.
  • A prepaid tuition plan lets you prepay for tuition at a specific college or university at today's price. For example, if you're determined your child will go to Harvard, where the 2019-2020 tuition is $47,730, putting $47,730 into the prepaid plan would get you one year of tuition when your child enters college—even if tuition is $100,000 when your child attends. If your child doesn't get into your desired college or decides not to go there, you can use the funds for tuition at another college.

What are the Benefits of a 529 Plan?

A 529 plan offers an easy way to save for college and enjoy the benefits of compound interest. Money is contributed to the plan after-tax and then grows tax-free. As long as the money is used for qualified educational expenses, no federal income taxes will be due when you withdraw money from the plan. (Some states may charge state taxes, so be sure to review the specifics of any 529 plan you're considering.)

A 529 plan may also offer tax benefits to the account holder. More than 30 states offer state income tax deductions or tax credits for contributions to 529 plans.

For grandparents or other relatives who want to give children a financial gift but are worried about how it might be used, 529 plans offer a way to be generous while still retaining control. The plan holder controls withdrawals, so Grandpa can rest easy that Junior won't blow the college fund hiring his favorite band to play his high school graduation party.

You can set up a 529 plan at any time, but because earning compound interest is key to maximizing growth in your plan, the ideal time to start one is when a child is born. That gives the plan 18 years to grow.

What are the Disadvantages of a 529 Plan?

The disadvantages of a 529 plan are fairly minor in comparison with the advantages, but there are some potential downsides to consider.

  • Potential tax penalties: If the funds in a 529 plan are used for anything besides qualified educational expenses, you'll pay taxes on the money withdrawn and an additional 10% penalty fee.
  • Prepaid tuition problems: If you chose a prepaid tuition plan and your child doesn't go to the specific college you chose or a college from the list, you can still use the money in the prepaid tuition plan to pay their tuition. However, if the tuition is more than the amount you prepaid, you'll have to make up the difference.
  • Investment risk: As with any investment, both prepaid plans and education savings plans involve risk. Depending on how your investment portfolio performs and whether your plan is guaranteed by the state or federal government, you could lose some or all of your investment. Carefully read the prospectus of any plan you're considering and make sure you fully understand the risks.
  • Restrictions on withdrawals: 529 plans limit the amount you can withdraw each year and have specific rules about what the money can be used for without triggering taxes and fees.

How to Use a 529 Plan

To avoid taxes and penalties, funds from a 529 plan should be used only for the following expenses:

  1. Required tuition and fees
  2. Room and board (for students attending at least half time)
  3. Books, supplies and equipment
  4. Computer or peripheral equipment (such as a printer), computer software and internet access

Funds withdrawn for these costs are called "qualified distributions."

Some common expenses that parents might consider education-related, such as the cost of flying your child home for the holidays or furnishing their apartment, are not qualified reasons for withdrawing funds from a 529 plan. Using the money for these purposes will trigger federal taxes and a 10% penalty fee on the earnings portion of the withdrawal. (You don't have to pay taxes or penalties on the principal portion of the withdrawal, since that money was taxed before you ever put it into the plan.)

Even qualified educational expenses have their limits. For each of the four qualified expense categories, you can't withdraw more than the school's estimated cost for that category in that school year. (You can find this information on the school's website.)

Suppose your son's school estimates the cost of room and board as $12,000 annually. If your son moves into an apartment that costs $1,500 a month and spends $400 a month on groceries, only $12,000 of that amount can be taken from the 529 plan. That leaves him (or you) to come up with $5,100 a year from other sources. Similarly, if the estimated cost of books and supplies is $1,200 but your daughter's textbooks end up costing $1,400, only $1,200 from the 529 can be used toward that cost.

Having 529 funds sent directly to the school to pay for tuition, fees, on-campus housing and other school charges helps to ensure there's no question about how you're spending the money. However, it's a good idea to consult your tax advisor and your 529 plan manager on the best way to withdraw the funds to avoid triggering problems with either taxes or financial aid eligibility. When you're withdrawing money for any expense not paid directly to the school, such as rent for an off-campus apartment, books and supplies, or food purchased outside of a campus meal plan, be sure to maintain receipts to document all the expenses.

Although 529 plans are meant for educational expenses, the plan holder can actually withdraw money from the plan for any reason. Just remember this will be treated as a "non-qualified distribution" and will trigger taxes and penalties.

Other Ways to Pay for College

If a 529 plan doesn't sound right for you, there are other ways to save money for college. For instance, you might want to start a plain old savings account, a taxable investment account or a Coverdell Education Savings Account for your child. You can encourage your child to start their own college savings account using earnings from a part-time job or money they receive as gifts. You could also investigate scholarships, grants and loans.

Although there are other ways to pay for college, a 529 plan is one of the best options around. It allows your child's college savings to earn compound interest and grow tax-free. And it lets parents or grandparents stay in control of the money. Best of all, it can help your child stay free of student debt so they can start adult life with one less expense to worry about.