This article is meant for people who may have heard about college savings plans and would like to know a little more. College planning for your children is a topic that can cover a wide variety of beliefs (should you foot the entire bill, how much should you save), options, programs, government incentives and different savings vehicles. There are also dozens of tool and calculators that help you answer these questions.
529 College Savings Plans
Saving money for your child’s education is an important thing to do, especially with tuition costs rising each year. Two of the most popular educational savings plans are the 529 College Savings Plan and the Coverdell Educational Savings Account (ESA). Both college savings plans offer tax advantages and may be good options depending on your needs. However, of the two plans, the 529 College Savings Plan offers a more flexible plan for many people, so we will examine these accounts and how you can use them to save for your child’s college education.
If you are a military family, you may be able to transfer your Gi Bill to your dependents to cover some or all of their college expenses. There are some other factors military families should consider, which are covered in this article – 529 college savings for military families.
Two Types of 529 Plans – Prepaid and Savings
There are two types of 529 plans, one is a prepaid plan and the other is a savings plan.
Prepaid 529 Plan. Prepaid 529 plans allow you to buy tuition credits at today’s costs, which can be used in the future. The advantage of this is the ability to lock in your college costs before inflation and time causes them to increase. Prepaid 529 plans are administered by individual states for state run universities, or by individual colleges.
529 College Savings Plan. The savings version of the 529 plan functions similar to a retirement account, but it is used for college tuition and eligible expenses. The savings plan can have different types of investments, such as Certificates of Deposit, mutual fund index funds, and ETFs. These plans offer more flexibility, but are subject to market returns, so you could potentially make or lose money. Savings 529 Plans are administered through states at times, but the actual record keeping and administrative work involved in the plans are typically handled by financial services companies or mutual fund companies.
What 529 Plan Savings Can Be Used For
Qualified expenses for 529 plan funds include tuition, room and board, books, supplies, equipment and college related fees required to study at any vocational school, accredited college or university program in the United States. Some foreign universities also qualify. 529 savings can be used in conjunction with the GI Bill to help pay for expenses not covered by your GI Bill benefits.
You may not use money from a 529 plan to pay back student loans or student loan interest, transportation costs, and similar education expenses.
Tax Advantages and Benefits of 529 Plans
Many people prefer the 529 plans for college savings vehicles because of their tax advantages.
- Tax deferred growth. Money in a 529 account grows tax-deferred and can be withdrawn tax-free if used for qualified educational expenses for the beneficiary of the 529 plan. The donor (person who opens the 529 plan) remains in complete control of the fund. Most 529 plans will even allow the donor to reclaim the money for themselves if things change, although the earnings portion of non-qualified withdrawals are subject to income tax and a 10% penalty. The assets returned to the donor are also not included in the donor’s gross estate for estate tax purposes.
- Tax deductions on contributions. Some states offer a state tax deduction or credit for contributions made to a 529 Savings Plan. Each state has different rules and there may be limits to the amount of contributions that are tax deductible. Contributions to a 529 are not deductible from federal income tax liabilities.
- Withdrawals may not be considered taxable income. When you take distributions from your 529 plan for qualified higher education expenses, the money is exempt from federal income tax.
- Watch out for non-qualified distributions. If you take money from your 529 plan for anything other than qualified educational expenses, the distribution is subject to income taxes and an early distribution penalty of 10% on the money the plan has earned except under a few circumstances.
Tax Disadvantages of a 529 Savings Plan
If you decide to make withdrawals from your 529 Savings Plan for something other than higher education expenses, you may be hit with penalties and taxes. In fact, the penalties are similar to the early withdrawal penalties for retirement fund. Any accumulated earnings are taxed, and you must pay an additional 10% penalty on your earnings.
529 Plan Eligibility
Everyone is eligible for a 529 plan – there are no income or age restrictions. The opening contribution generally has a low minimum requirement, and the ongoing contribution requirements are low, as well. This makes the 529 plan a powerful tool for college planning.
Ability to transfer 529 funds to family members. Another benefit of 529 plans not commonly found in college investment vehicles is the ability to transfer the money from one beneficiary to another family member without penalty. Qualified family members may include son, daughter, step children, adopted children, foster children, siblings and step siblings, parents, step parents, nieces and nephews, aunts, uncles, in-laws, first cousins, or the spouse of any qualified family member.
Where Can You Open a 529 Plan?
Each state has it’s own version of the 529 plan and you can choose to invest in a 529 plan from your state or from another state. However, it’s often more advantageous to invest in a 529 plan within your state of residence because many states offer tax advantages and potential scholarship opportunities. Additionally, 529 plans from your state of residence are exempt from financial aid calculations, meaning the money saved in the plan won’t prevent your eligibility for other sources of financial aid programs.
Each state can offer their own 529 college savings plan and there may be differences among plans offered.
Further Reading for College Savings:
The following articles go into additional details regarding various college savings plans and accounts, the pros and cons of using them for your savings, and how you can use them to help pay tuition and other education costs for yourself or your children.
- 529 College Savings Plans vs. Coverdell ESAs.
- How and Where to Open a Coverdell ESA Plan.
- My GI Bill and 529 Plan Experience.
Check with your state 529 plan for more details
This article only includes a brief overview of the advantages and disadvantages of 529 plans. For more information, I recommend checking with the IRS or your state individual plan.