It’s never too early—or too late—to start saving for your child’s college fund. Whether college is three or ten years off, there are many options available that can help you save for college expenses, while also offering you tax benefits.
A 529 savings plan is a tax-advantaged investment plan designed to encourage saving for future education costs. Named after section 529 of the Internal Revenue Code and legally known as qualified tuition plans, 529 plans may be sponsored by states and state agencies, as well as authorized educational institutions.
There are two types of 529 plans. The plan that’s right for you will depend on your time frame, flexibility, and risk appetite.
Prepaid tuition plans: These allow you to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and board. Most state governments sponsor prepaid tuition plans and many guarantee the investment plans that they sponsor. These plans often have an age or grade limit for the beneficiary and require either the owner or beneficiary of a plan to be a state resident.
A prepaid tuition plan might be better for you if you don’t have a lot of time before your child plans to go to college. You can put a lump sum into the plan or set up installment payments to lock in the current price of college for a later date of attendance. In addition, with less time to invest, it’s better to avoid taking too much risk and since prepaid tuition plans lock in a set price and have a state guarantee, there is minimal risk involved.
Prepaid tuition plans would also be the better option if you know your child will be going to an in-state college, as most of the plans have residency requirements.
College Savings plans: These allow you to set aside money for your child’s education and let it grow tax-free. You can typically choose among several investment options, which include stock mutual funds, bond mutual funds and money market funds. As long as the money is used for higher education costs, the government won’t tax it when you take it out of the account.
Unlike prepaid tuition plans, withdrawals from college savings plans can usually be used at any college or university at any state.You don’t have to invest in the plan sponsored by the state you live in—you can choose any state that meets your needs—but you may face higher commission rates and more limited investment options. Additionally, you may be able to take advantage of state tax benefits if you invest in the state you reside in.
While most prepaid tuition plans cover tuition and mandatory fees only, money from college savings plans can go toward tuition, room and board, and required books and equipment, in addition to tuition. They also do not have age limits or residence requirements.
However, they often have contribution limits in excess of $200,000 and are not guaranteed by states.
These plans might be better for you if you have a longer amount of time to save for your child’s college. With more time to invest, you would have the ability to be more aggressive with an investment plan in order to grow your savings. This option is the more risky of the two, since the prices are not locked in, and you could break even or even take a loss on your investment.
Perhaps the greatest benefit of the savings plan option is the flexibility it offers. You and your child may have no idea what college he or she will end up at. Prepaid tuition plans limit you to schools within your state, but the savings plan allows you to choose from a larger variety.
Investing in 529 plans may offer you special tax benefits. Earnings on the plans are not subject to federal tax, and in most cases, state tax, as long as you use the money for educational purposes. Most states also wave income tax or offer other benefits, such as matching grants, for investing in a 529 plan.
If you do not use the money for college expenses, you will likely be subject to income tax and an additional 10% federal tax penalty on earnings. In addition, there may also be other consequences associated with withdrawing money from the 529 plan like, for example, rolling out money from your home state’s plan into another state’s plan. Before you complete a withdrawal, be sure to read your plan’s documents to make sure you understand the associated costs.
(Also read: Tax Breaks Everyone Should Know.)
Other College Saving Plans
Coverdell education savings accounts: Theseare another good tax-advantaged option if you are planning to pay for other educational expenses or if you want more investment options. ESAs can include money that will go toward a primary and secondary school, in addition to colleges. They also have lower maximum contribution limits, can be affected by the income level of a contributor and they offer more investment options in stocks, bonds and mutual funds.
Custodial accounts: Theseare probably the most flexible types of savings accounts for your child. Basically, it’s an account you can set up for your child under the age of 18 to 21, depending on state legislation. You manage the account and determine how the money is invested and when to take out money to spend on your child’s behalf. Custodial accounts are not tax-deferred. Up to a certain annual amount, earnings are tax-free. Up to a certain amount above that, the earnings are subject to your child’s tax rate. Beyond that, earnings will be taxed at your rate.
You can learn more about 529 plans by visiting the Securities and Exchange Commission to decide if they’re right for you. If you’re ready to get started today, you can enroll at Savingforcollege.com or College Savings Plans Network.
If you think you will need some help, you can call a brokerage firm to help you choose the right savings plan, although not all firms offer all 529 plans.