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Set Aside Funds for College Expenses With College Savings Plans

Written by Kevin L. Matthews II

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
Here is a list of expenses that do not qualify:
  • Travel
  • Research
  • 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

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.

Anti college
Anti college   |     |   Comment #1
If I knew then what I know now, there would have been no US collage for my kids. The money are no objects if they are though how to be free thinkers, independent and responsible citizens. I said that because my kids were indoctrinated in college, not only socially but psychologically, made dependent on others for any major decision, made dependent on the friends common thought and made them with inferior complex. The knowledge they acquired is on sub par from the same age kids from other countries of the world. Our kids are afraid from the truth and they think, if not agreeing with the rest of the friends, will make them odd balls and anti social.
There will be no US college of any kinds for my grand kids, There is no need for such huge sum of money for college, they are going abroad to study. Most of us already know, that the US colleges are run by the book of "Alinsky" and the professors will do a number on our kids to make them ready for socialism.
Mak   |     |   Comment #2
My son is doing pretty good in college so I'll take my chances.
Anti college
Anti college   |     |   Comment #4
Mak #2, if you are ideologically on the left side of the spectrum, it will seams natural to you and you will accept the indoctrination like a natural process, not for the rest of the country or if you want to raise independent and self thinkers (on a higher level of conscience).
deplorable 1
deplorable 1   |     |   Comment #7
@Anti college: I figure if I raise my kid to be a independent thinker no amount of liberal indoctrination is going to brainwash her. Maybe this is just wishful thinking on my part. Peer pressure can be a very powerful force though. I was pretty liberal in my thinking right up until I went in the military and got out on my own.
Anti college
Anti college   |     |   Comment #12
deplorable 1- comment #7, I congratulate you on your great awakening, now you know what is like to be a free spirited and independent thinker. We owe are kids the same (politically and socially free education), the power they will feel is God's given right. Most of the people on the left can never achieve such greatness and will always blame the "right" for their own failures.
Chucky   |     |   Comment #18
Trump is not a leftist, but he does a pretty good job blaming everyone but himself.

Perhaps the real problem is you, and every partisan.
deplorable 1
deplorable 1   |     |   Comment #6
I somewhat agree about the liberal college professors brainwashing the kids but I will let my kid decide on her own what she wants to do. You have to eventually let your kids make their own decisions and choices in life. Hopefully if you did a good job of parenting so they will make the right ones. I want her to have choices whether that is college or a different career path. College was not for me personally as I was too busy working a skilled trade, making money and investing. By the time my friends graduated from college I had $100,000 saved and a good paying job while they were broke, in debt and still living at home with mom and dad. They all thought they were going to make big bucks with a degree because this is what they were told. Long story short I retired at 30 and they are all still working.
deplorable 1
deplorable 1   |     |   Comment #3
I have my kids college fund in a custodial brokerage account invested in high yield monthly paying dividend stocks. All profits are tax free until she earns enough to get slapped with the the kiddie tax. It cost me $0 to set this up with Folio investments and she can use it for anything not just college like a first car for example. This is her money though and I'm hoping to grow it into a college fund. I don't believe in paying for your kids college. I think they need to work and pay their own bills(like I did). Today's youth expect everyone to hand them everything on a silver platter. I'm trying to teach my kid some personal responsibility. It's tough in a world of kids with a entitlement mentality and enabling parents who are willing to go into debt themselves and sacrifice their own retirement in many cases in order to please their kids.
TABJ   |     |   Comment #5
There's an error in the article. Room and board are considered qualified expenses.
Ken Tumin
Ken Tumin   |     |   Comment #19
Thanks for letting us know about this error. The article has been updated with the correct information on the qualified expenses.
Matt   |     |   Comment #8
Room and board are eligible to be paid through 529 plan. Otherwise 529 plans become much less helpful. For an article about college savings surprised that has been published incorrectly.
anonymous   |     |   Comment #9
How about using the parent's Roth IRA as a college funding vehicle instead? Can be invested in anything and the funds will not be considered the student's assets.
Mak   |     |   Comment #10
You can use EEs or I bonds to pay for college tuition and if you do it right you won't pay the taxes on the interest from those bonds..... I have some that mature in 4 years so I can use them as long as I'm under the income limits.
deplorable 1
deplorable 1   |     |   Comment #11
@anonymous: Interesting idea but how would you keep the funds separate and you would be losing your contributions to your Roth IRA for that same amount. As long as they earn less than $2,100/yr. in interest and dividends it is tax free for them anyway.
anonymous   |     |   Comment #14
Deplorable 1, why keep the funds separate? You can just withdraw them as necessary from your own account. Of course, you can only withdraw Roth contributions tax free (not earnings). I believe you can withdraw Roth earnings penalty-free (but not tax free) for a child's eligible education expenses.

The drawback is basically that you wouldn't have tax-free earnings in addition to the Roth IRA, you'd have to plan to use it either for education or keep it growing tax-free for retirement.

I think I also read somewhere that the parents' retirement savings are usually not counted for the expected family contribution, but I'm not sure if this is true. If so, it makes even more sense to try to get the college funds somehow into a retirement plan.
anonymous   |     |   Comment #15
My opinion is that 529 plans are too restrictive for the tax benefit they provide. What if a child does not want to go to college? The 529 will have the most earnings power when the child is still young, but this is also the time when they don't have any defined career plans yet. As time goes by, children's plans become more well defined, but the 529 will not have that much earnings power left.

So my solution is to stick as much as possible into retirement plans ... 401(k), Roth IRA, and Mega Backdoor Roth.
deplorable 1
deplorable 1   |     |   Comment #16
@anonymous: Exactly! What if your kid chooses a different career path? What becomes of that money? I chose a standard brokerage account because I can buy, sell and withdraw earnings at anytime and put it back into savings/CD's or bank bonuses. I need the flexibility to move that money around to make it grow. $2,100 a year is tax free anyway and when she has earned income I'll set her up with her own Roth IRA. She has a linked savings account(Discover) and a CD earning 2.5% as well. Everything is in her name(custodial) which is nice as I like to keep her money separate.
Att   |     |   Comment #20
Note that some states (NY is one of them and I believe 29 others and DC) allow 529s to pay expenses only for higher education and not K-12. ."The New York State Department of Taxation and Finance issued a Preliminary Report to the Governor on H.R.1 indicating that K-12 distributions may not be considered qualified distributions under New York statutes and may require recapture of any New York State tax benefits that accrued on contributions. NY 529 account owners in other states should seek guidance from the state in which they pay taxes."
Att   |     |   Comment #21
My comment #20 In NY you may take a tax deduction of $10,000 per year so those benefits and other state benefits would not be considered qualified distributions. I assume the Federal benefits are not affected.

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