One of the top priorities of many young families I talk with is to save for their children’s college. College costs are rising quickly, and parents are seeing an opportunity to help the next generation along the way.
Fortunately, the U.S. Government sees it the same way. A section of the IRS tax code--Section 529--created a special savings account, administered by the states, to help families pay for college expenses.
Here’s some information on how 529 plans work, their advantages, and three pointers to get started using one.
What are 529 plans exactly?
529 plans are college savings accounts which can be used to help pay the college expenses of another individual. They are run separately by each state. To date, nearly every state maintains its own 529 plan (except for my state--come on, Wyoming!)
Any money that is saved essentially counts as a “gift” to the beneficiary of the account, though you maintain control of the account. This saved money can be used to pay college costs, with the added bonus of some unique advantages.
Contributions can really add up, too! Most 529 plans allow a maximum account balance of around $250,000! There are no income limits for those contributing as well, unlike IRAs which are disallowed for families over a certain AGI.
How your 529 plan can be used
The cost of college in recent history has climbed around 5% to 6% each year, though it appears that may be coming down a bit. Still, prices are hefty, especially in the ivy leagues!
Since college is so costly, it’s a relief to many to learn the variety of costs a 529 plan can cover. These expenses include:
- Tuition
- Fees
- Books
- Reasonable costs for room and board
Students need to at least be half-time to be eligible to use 529 funds.
What if college isn’t in the future of your son or daughter? 529 plans can also be used for vocational and trade schools, adding some nice flexibility. And speaking of flexibility, the beneficiary of the 529 plan can also be changed. If a child decides not to attend college or there is money left their 529 plan once they graduate, the owner of the account can change the beneficiary of the proceeds.
How investing works in 529 plans
One of the greatest features of 529 plans is the ability to invest your money tax-free. Each state’s college savings plan allows you to invest in mutual funds. Often these funds are broken into two separate categories: static and age-based mutual funds.
“One of the greatest features of 529 plans is the ability to invest your money tax-free.”
Static mutual funds keep the same investment allocation over time. If you want to change your allocation to a less aggressive one, you need to pick a different mutual fund.
Age-based mutual funds adjust their investment allocation automatically over time, from more aggressive investments for young beneficiaries, to less aggressive investments for beneficiaries approaching their college years.
When you open your 529 plan, you’ll elect your investments up front, but they can be changed later at any time.
The tax advantages of 529 plans
As with other types of investment accounts like Roth IRAs, 529 plan contributions go into the account on an after-tax basis, meaning there is no tax deduction for contributions made. However, growth within the 529 as well as the distributions later are tax-free, as long as they are used for eligible college expenses.
Since 529s are run state by state, each state sets some rules for how the accounts are maintained. In some cases, states may offer tax incentives for residents who participate in their state plans. The Utah Education Savings Plan, for example, offers a tax credit to eligible participants who live in Utah.
“...states may offer tax incentives for residents who participate in their state plans.”
How to get started saving for your child’s education
The process of understanding when and how much to save for college can be a daunting, complex one. In fact, there are financial planners who directly specialize in providing college funding advice (including applying for and paying off student loans) by helping families navigate its complexities.
A good place to start is to consider these three questions:
1. Where will my child likely attend school?
This is tricky to know, especially if you’re planning to start saving for a newborn. Many families have a tradition of attending an alma mater which may make the decision easier, but this isn’t always to case. It’s often best to pick the most likely college of attendance and adjust your savings plan if things change.
2. How much will I need to have saved up?
Once you know which school your child is likely to attend, you can project the expected costs. The financial planning tool I use with my clients, RightCapital, has a helpful index where you can look up a college and find the future expected costs of attending. If you’d like to do a quick assessment of future college costs using RightCapital, give me a holler.
3. How much should you start saving now, each month, to get there?
When you know the future costs of college (they’re probably scary looking!) you can break the future cost down into current payments into your 529 plan, assuming a certain rate of investment return. There are many tools available to give you an idea of how much you’ll need to save every month, such as this 529 College Savings Planner.
I hope this post has been helpful. College Savings Plans (529s) are incredibly useful, flexible tools for college savings. They aren’t without a few flaws, but their tax advantages, investment options, and high contributions limits make them tough to beat compared to other saving options.
If you have questions about how 529s may work in your own family’s financial situation, get in touch with me or leave a comment below.