It’s no secret that college is expensive.
In fact, many families are stuck with a financial burden that endangers their short and long-term savings goals.
But as costly as college may be, there’s no doubt that higher education is, in most cases, essential to achieving the American dream.
Fortunately, there are powerful investment strategies available to help cover the cost of college.
With a 529 college savings plan, you can help ensure your children (and grandchildren) will attend the schools of their dreams, without jeopardizing your financial future.
What Is a 529 Savings Plan?
As the name implies, a 529 savings plan is an investment vehicle designed specifically for college savings.
As such, it provides tax-free investment growth and withdrawals for qualified education expenses, like tuition, fees, housing, and academic supplies.
In other words, the money invested in a 529 plan grows on a tax-deferred basis until it’s withdrawn to help pay for college. As long as the money is used for qualified education expenses, the withdrawals will never be subject to state or federal taxes.
Note: while 529 plans don’t have annual contribution limits, they do have total “lifetime” contribution limits. In most cases, the aggregate limit is over $500,000.
The Two Types of 529 Plans
There are two main types of 529 plans to choose from:
- Education savings plans.
- Prepaid tuition plans.
Most states offer at least one of them. While many states offer residents a state tax deduction for investing in their 529 plans, you have the freedom to pick a plan from any state.
Though they serve the same purpose, each plan features some important distinctions.
Education Savings Plans
In a 529 education savings plan, money is invested in a curated list of stocks—like a mutual fund.
Though account holders can select their top investments, available choices are more limited than in a money market account or individual retirement account (IRA).
Note: while withdrawals from a 529 plan are often directed to college tuition, they can also be used for qualifying K-12 education expenses.
Prepaid Tuition Plans
The cost of tuition is expected to increase by 7% per year over the next 20 years. That’s where prepaid tuition plans can help.
By prepaying part (or all) of in-state public tuition, families can cover the price of college as it currently stands—not as it will be in 2042.
As of today, only eight states offer prepaid 529 plans:
- Florida
- Maryland
- Massachusetts
- Michigan
- Mississippi
- Nevada
- Texas
- Washington
Note: unlike 529 savings plans, prepaid tuition plans can only be used for higher education institutions and are not available for K-12 education.
Benefits of a 529 Plan
The tax benefits of a 529 plan can help college-bound families save a tremendous amount of money.
While taxation is inevitable in most areas of life, 529 plans protect families from the high cost of federal and state taxes during the growth stage of the investment and its eventual withdrawal.
Better yet, many states exclude 529 plan distributions from taxable income, and some even offer a state income tax credit for 529 plan contributions.
Other benefits of 529 plans include:
- Low maintenance: families can easily open and manage a 529 account. After selecting an automatic investment plan linked to a bank account, users can simply “set it and forget it.”
- Broad flexibility: as mentioned above, families have the ability to invest in almost any 529 plan—no matter where they live or where their child will ultimately attend college.
Just be sure to carefully research all available 529 plans before committing to one.
Disadvantages of a 529 Plan
Though there are many positives to 529 plans, there are a few potential disadvantages to keep in mind:
- Non-qualified withdrawals get penalized: if you use the invested money for anything other than college or K-12 (if applicable) costs, it will be assessed a 10% tax penalty on top of your regular income tax.
- Limited investment choices: though 529 savings plans offer compelling investment options, more experienced investors may feel the options are too limited or too low-risk.
- Possible fees: expenses often vary among 529 plan portfolios. For example, 529 accounts sold by financial advisors typically carry higher fees than 529 accounts you choose and manage on your own.
That said, a 529 can still be a great option for you and your family.
How to Start a 529 College Savings Plan in 5 Steps
While 529 plans might seem daunting at first, they’re quite easy to open and manage.
In fact, there are only five key steps.
1. Select a Plan
As we mentioned earlier, you’ll have to choose between two kinds of accounts: a savings plan or a prepaid plan.
Keep in mind that you won’t be limited to just one 529 plan. If it aligns with your financial needs, you can open several 529 plans across multiple states.
If you aren’t sure which plan is best for your financial situation, consider contacting a financial advisor or a 529 plan broker for advice.
2. Choose a Beneficiary
While most 529 plans are opened for one’s children, they are not limited to any specific type of relationship.
There are only two important requirements for your beneficiary: that they are a U.S. citizen or resident alien, and that they have a Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN).
3. Open an Account
Most 529 savings accounts can be opened online.
If you already have a brokerage account (like a Fidelity or Charles Schwab account) you’ll be able to open a 529 account very quickly. Simply log into your account and search “529 plan” to get started.
Be sure to have your SSN (or ITIN) on hand, along with your date of birth, address, and contact information.
Note: if you’re new to the world of investing, check out our comprehensive guide to the stock market.
4. Fund Your Account
After you open your 529 account, you’ll then be able to fund it.
In other words, you can start depositing funds directly into the account. While some brokerage accounts may require a minimum deposit, others do not.
Look out for any fees associated with providers and plans. Some plans may charge annual fees, account opening fees, and fees for the assets under management (AUM). Always read the fine print.
5. Select Your Investments
Now that your account is open and funded, you’ll be able to start building your portfolio.
Take some time to review the available investment options.
Keep in mind that most 529 accounts offer a tailored selection of plans comprised of age-based target-date funds.
In other words, the available mutual funds are designed to start out aggressively and become more conservative as the date of withdrawal approaches.
Note: need to make changes? You’ll be able to adjust your 529 plan investments twice a year.
529 College Savings Plans FAQs
You might have more concerns about 529 accounts. Here are some helpful answers to your most pressing questions.
1. What Happens if Your Child Doesn’t Go to College?
529 accounts never expire, even if your child decides not to attend college.
You’ll be able to change the beneficiary to leave the funds in the account to that person. The new beneficiary must be a family member of the original beneficiary.
Or, if you need to withdraw the money, you’ll be able to do so—though you will likely have to pay taxes and an additional fee.
2. What Are “Qualified Expenses”?
Qualified expenses for a 529 plan generally include:
- College, graduate, or vocational school tuition and fees.
- Off-campus housing costs.
- Academic books and school supplies.
- Computers, laptops, internet, and software used for schoolwork.
- Student loan payments.
- Campus food and meal plans.
- Accessibility costs for special needs students.
Any and all withdrawals for these costs will be 100% tax-advantaged.
3. What Are 529 Plan Transferability Rules?
The owner of a 529 plan may transfer the plan once per year—unless a beneficiary change is
involved.
According to the federal tax code (Section 529), you can legally transfer the plan to another family member.
4. Can a 529 Be Used for Trade or Vocational Schools?
Absolutely!
While many 529 plans are used for traditional four-year programs, the invested funds can also go towards two-year associate degree programs, trade schools, technical schools, and vocational schools.
5. Is a Roth IRA Better Than a 529?
While IRAs have broader investment options than 529 plans, they are generally less effective as college-savings tools.
The reason is simple: most IRAs have low contribution limits at just $6,000 per year.
Some Roth IRAs contributions are phased out when your income exceeds $129,000 (filing single), whereas the 529 plan has no such restrictions.
Finally, IRAs will be subject to income tax upon withdrawal and be counted as income for the Free Application for Federal Student Aid (FAFSA®) form the following year.
When compared to other investment vehicles, the tax benefits of 529 plans are unrivaled.
Moving Forward
While college can be a daunting investment, it’s the best launchpad for your child’s financial future.
Start planning as early as you can, and if possible, partner with a financial advisor who can help you reduce the cost of your total investment.
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