We can all pretty much agree that a college education is an investment in any young adult’s future — and a significant one at that. The average net cost of a four-year degree today is over $58,000. And, according to Fidelity’s Annual College Savings Indicator study, parents are on track to cover only 29% of college tuition by the time their child reaches college age.
One common way parents can save for their child’s future college expenses is by using a 529 college savings plan. 529 plans were created in 1996 as a part of the Small Business Job Protection Act. The official name of the plan is a “qualified tuition plan,” but it was nicknamed after Section 529 of the Internal Revenue Code.
These college savings plans allow you to contribute to the cost of college with certain tax advantages. Today, the benefits of a 529 college savings plan now extend beyond higher education alone. As of Jan. 1, 2018, new tax laws allow parents to use up to $10,000 (per year, per student) saved in a 529 college savings account to fund K-12 education as well.
Tax advantages of college savings plans
Similar to a 401(k) and traditional IRA, 529 college savings plans are investing accounts that provide tax deferred growth, which means the money you put in the account can grow free from taxation.
If you use 529 funds that are classified as earnings to pay for nonqualified expenses, your withdrawals could be subject to ordinary income tax as well as a 10% penalty.
However, there are some situations where this can be avoided: “The penalty may be waived if there are extenuating circumstances, such as the disability or death of the beneficiary, or if he or she receives a scholarship, veteran educational assistance, or other nontaxable education payment that isn't a gift or inheritance,” according to Fidelity.
Rules of the 529 college savings plan
The earnings from this college savings account are also tax-free if used for qualified educational expenses. The IRS defines qualified education expense as:
- Tuition and fees required to enroll at or attend an eligible educational institution
- Course-related expenses, such as fees, books, computers, supplies and equipment that are required for the courses at the eligible educational institution. These items must be required of all students in your course of instruction
- Special needs services as long as they're related to postsecondary classes
- Room and board as long as the individual is at least a part-time student
- Clerical help
- Equipment and other expenses that aren't required for enrollment in or attendance at an eligible educational institution
How much you can contribute
Currently, you can contribute up to $15,000 per parent per year into a 529 college savings plan, or a total of $30,000 per couple. Anything over $15,000 must be reported to the IRS for gift tax purposes. According to Fidelity, these college savings plans can also be “superfunded” allowing an individual to add $75,000 per person or $150,000 per couple. Superfunding will, however, use up your federal gift tax exclusion for five years.
Also, a 529 college savings plan is an investing account. You’ll also need to determine the amount of risk you are willing to take, how long you have until the child starts school and the cost of the school he or she may be interested in.
The difference between prepaid tuition plans and college savings plans
When one mentions a “529 plan” it actually encompases both prepaid tution plans and college savings plans, but the latter is most often referred to when talking about 529s. Both prepaid tuition plans and college savings plans share the same goal of helping families save for the cost of education, however the two options work differently.
Prepaid tuition plans allow you to pay for tuition now for use in the future. With prepaid tuition, you may have a contract plan (which is the most common) or a unit plan. With a contract plan, you are trading your upfront cash, and the plan promises “to cover a predetermined amount of future tuition expenses at a particular college in the plan” as described in the WealthBridge Advisors guide: The ABC’s of 529 Plans.
Unit plans allow you to buy a percentage (also known as a credit) of the cost of tuition today for use in the future. One unit typically equals 1% of a year’s tuition. Prepaid tuition plans aren’t tied to the stock market in the same way college savings plans are. If there is a market correction at the time you need the money for college, a prepaid plan may be more beneficial.
FinAid states: “A key potential benefit of prepaid tuition plans is they tend to act as a hedge against economic downturns. During recessions and for a year or two afterward, state governments tend to reduce support for higher education. This translates directly into increases in public college tuition rates. So when other investments are dropping due to a declining stock market, prepaid tuition plans will tend to increase.” Though prepaid tuition plans are guaranteed to increase in value at the same rate as college tuition, there are some disadvantages.
“As college prices continue to skyrocket, this is a great way to lock in savings through a lower cost of college,” personal finance expert Eric Rosenberg told DepositAccounts. “However, keep in mind that those funds are tied to specific in-state universities.”
Prepaid plans are typically run at the state level and can generally only be used at in-state public schools. If you or your child decided to attend a school out of state or a school that does not take prepaid plans, you could lose out on some of the benefits depending on the state. You can however roll the money over to another 529 college savings plan, change the beneficiary or withdraw the money to pay another college directly. The risk is whether or not the tuition at the school (or state) you saved for is going to cover the same amount at a different school.
If your child chooses a private institution, he or she will need to check if that school has sponsored a 529 prepaid tuition option. Currently, there are 300 private higher education institutions that offer prepaid plans. You can see a full list here. 529 college savings plans are generally a lot more flexible in allowing you to pay for nearly any school you get into.
Lastly, not every state offers prepaid tuition plans and many states have closed their programs, whereas the 529 savings plan option is available in all 50 states and the District of Columbia.
How college savings plans interact with financial aid
You have to report any college savings plan fund when you fill out the Federal Application for Financial Student Aid each year. If you save for your child in a 529 college savings plan, you should know that college financial aid offices will consider that account as available income when assessing your child’s need for financial aid. (Merit-based grants and scholarships are not affected by 529 plans.)
This should not discourage you from saving, however.
“Using a 529 college savings plan is still one of the best ways to save for college, even given that it can impact your financial aid,” said Robert Farrington, college savings expert at TheCollegeInvestor.com.
How to find the best college savings plan for you
Not all 529 college savings plans are created equal. Their historical performance, tax benefits and reputation can vary depending on the provider you choose.
“In general, most people will want to look at the plan offered by their state, especially if you live in a state that offers a deduction for contributions,” Farrington said.
In some states, you may qualify for an additional tax deduction by choosing a school that is in your area and a plan sponsored by the state. But Farrington says that there are six states that allow you to take a deduction no matter which state’s plan you’re contributing to. Those states are: Arizona, Kansas, Missouri, Montana, Maine, Pennsylvania.
If you’re looking for plans based on state tax benefits, Saving for College has a 529 college savings plan aggregator and rating system that allows you to sort and choose based on your chosen characteristics. Search for the top performing plans across all states here. Choosing to go with a plan that is not sponsored by your state has benefits and drawbacks that you’ll want to consider.
You could lose out on an additional tax break by choosing a plan and school that is not in the state you currently live in. However, the out-of-state plan may have a better performance history and less fees. You will want to carefully weigh these factors or speak with a financial planner when making your decision.