What is a 529 College Savings Plan? How to Save for Your Student’s College Fund

It’s no secret that college is expensive. With over $1.5 trillion in student loans borrowed in 2019 and college prices continuing to rise, it’s surprising that the average parent has only saved $18,000. In the same report, even more shocking is that 35 percent of parents are not planning on saving for college.

While undergraduate loans can help pay for your student’s education, every dollar saved now can help your student when it’s time to go to college. Where do you start? Opening a simple savings account can work, but it won’t maximize your funds over time. That’s why nearly 44 percent of parents in the U.S. saving for college are using a 529 college savings plan.

What is a 529 plan?

A 529 college savings plan encourages families to save for future education costs, like going away to college and operating by a state, nonprofit, or educational institution that offers tax advantages to families.

There are two types of plans: the 529 college savings plan and the 529 prepaid plan. The college savings plan is the most common type of college savings plan and allows investments to grow tax-free. The prepaid plan allows you to prepay tuition for an in-state public institution at a locked-in cost today, which will likely be lower than what you would pay in the future.

You can find a list of all the 529 plans offered by the state here.

How does a 529 plan work?

529 plans vary in how they work depending on the type of plan. According to the U.S. Securities and Exchange Commission, there are two types of 529 plans–prepaid tuition plans and education savings plans.

Prepaid Tuition Plans

With prepaid tuition plans, families can purchase credits or units at specific colleges and universities for future tuition costs or fees, except for room and board. Prepaid tuition plans are sponsored by state governments, not the federal government. Depending on where you live, your state may have requirements for the school you select. 

Education Savings Plans

With education savings plans, families can open an investment account to pay for future education costs like tuition, fees, and room and board (unlike prepaid tuition plans) for up to $10,000 per year. Education savings plans can also be used at any college or university, including non-U.S. colleges or universities.

For each type of 529 savings plan, the account holder (usually a parent) contributes and invests it, typically in mutual funds. According to Investopedia, a mutual fund is a type of financial vehicle made up of a pool of money collected from many investors. Money managers then allocate the funds to produce capital gains or income for the investors through professionally managed portfolios. The money made from the plan is then tax-deferred, which means when your student goes away to school, you can withdraw the funds without a tax penalty from the plan. These funds can help cover tuition, room and board, or other educational-related costs. 

Is there an age limit on a 529 plan?

529 college plans are relatively flexible, which is one of their appeals, and there is no age limit to get started. You can use it to pay tuition at a four-year undergraduate program. If there is money left over in the plan, you can use it later to help cover continuing education or even to help pay back graduate student loans.

If your child doesn’t go to college or graduate school, you could always withdraw the money or use the funds to pay for other expenses — but it will cost you. If you use the money in your 529 plan to pay for unqualified education expenses, you will have to pay federal income taxes and a 10% penalty on the earnings.

Do you need to open a 529 plan for each child?

Technically, you can use the same college 529 plan for multiple children; however, there is a caveat to that. You can only have one beneficiary named to the account, which means only one child will use the plan to help pay for school at a time. If your children are far enough apart in an age where they aren’t attending college simultaneously, you can transfer the 529 plan from student to student when the time comes.

If your children are close in age and will be attending school at the same time, they cannot both pull money from the fund. For this reason, you may want to create separate 529 plans for each child if they are closer in age.

How do you open up a 529 plan?

To open a 529, you should start by shopping around. When in doubt, it’s often best to go with your state’s 529 plan, as most states offer state income tax deductions on the contributions you make toward your 529 plan. 

Once you select between prepaid tuition or education savings 529 plans, you will need to complete an application process, and then you can begin making contributions. Many plans will allow you to set up automatic payments linked to your bank account.

Who can contribute to a 529 plan?

While there can only be one account holder on the 529 plan, anybody can contribute. Grandparents, aunts, uncles, or friends can all invest in your student’s future by contributing to the 529 plan. Be sure to recommend it as an option during birthdays, holidays, graduations, and other special occasions!

Is it better for a parent or grandparent to own a 529 plan?

Grandparents can open 529 plans for their grandchildren. However, that money will count as untaxed income for the student, greatly affecting their ability to get help through federal financial aid. Parents should own 529 plans.

What are the advantages of 529 plans?

Tax-Free Distributions

One of the most touted benefits of 529 plans is that coupled with their tax-free investment growth, and when you start to pull money from these accounts, it will also be tax-free (if used for eligible school expenses). However, withdrawals from your 529 plans are not subject to federal income taxes but may be eligible for state income taxes.

Suppose you compare a 529 plan to another common savings account like a mutual fund. In that case, the 529 plan will save you the cost of paying a 15 percent capital gains tax and, for investments held for less than 1 year, the percent of the tax due on ordinary income. When planning for college, that savings can make a big impact on your bottom line.

State Tax Benefits (Some States)

Another benefit for some 529 savers is that over half of states (and the District of Columbia) offer state tax benefits to those who contribute to 529 plans. For example, Arizona allows residents to receive a tax deduction of up to $4,000 of their contributions to any 529 plan. In contrast, Massachusetts allows residents to deduct up to $1,000 of their contributions to the MA 529 plan.

Investing in a 529 plan may offer families special tax benefits. These benefits vary depending on the state and the 529 plan. In addition, state and federal laws that affect 529 plans could change. You should understand the tax implications of investing in a 529 plan and consult a tax adviser.

Adaptability

A unique characteristic of 529 plans is that they can be transferred or rolled over to other family members. When opening a 529 plan, a beneficiary (student/child) is named, but if that child decides not to go to college or doesn’t end up needing all the funds in the account, you can transfer the funds to a sibling or even yourself. This can be done tax-free, just like a retirement account rollover. This provides flexibility and adaptability for an unknown future.

What are the disadvantages of 529 plans?

Overall, a 529 college savings plan is a good idea for anybody who wants to start saving up for their children’s education. There are, however, some disadvantages you might want to consider before opening a 529 plan:

• Could limit financial aid. Colleges consider if the student has a 529 plan and could give less financial aid to students who have one. They are considered parent assets on the FAFSA®.
• Not much control over investments: Investment options for 529 plans tend to be very limited, which could impact your ability to control where your money is going.
• Penalties for non-school-related withdrawals: Not only will non-qualified withdrawals be taxed, but they are also subject to big penalties.
• Fees: 529 plans can come with costs that do not save for your child’s school. Make sure you understand all the associated fees before opening a 529 plan.

As with most investments, investments in 529 plans may not make any money and could lose some or all of the money invested.

Are 529 plans worth it?

If you are planning on saving for your student’s education, opening a 529 plan is an option worth exploring. The tax savings can add up fast, and having a dedicated 529 plan can help ensure your savings go toward your student’s education. Before opening a 529, you should understand the plan’s details and ensure that saving this money and making regular contributions will not put you in financial hardship. 

In addition to a 529 plan, there are multiple ways you and your child can help pay for school, including scholarships and federal financial aid. If any gaps in expenses remain, you can also consider private student college loans, including loans with cosigners and student loans without a cosigner. 

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