Note: We usually write to students and for students, but sometimes there’s a topic that is important enough to involve parents, and this blog post is going to cover one of those topics. That’s not to say that this topic isn’t of interest to students, because it is something that directly influences their college experiences, but the information contained within this post is going to be most useful to parents of young children and individuals who may one day have children of their own.
There are any number of ways to pay for college. Together, you and your child can fill out the FAFSA, and this may result in grants, a work-study position, or loans. Your child may qualify for in-state tuition, provided they have residency, or receive additional money from their college because of high grades or athletic abilities. Encourage your child to apply early and often for private scholarships to cut back on the cost of tuition and to supplement both their federal and institutional financial aid packages. (In fact, kids as young as five years old are eligible to apply for the Doodle 4 Google scholarship!) All of this financial aid, though, may still not be enough to cover the cost of tuition, books, and room and board.
That’s where a 529 savings plan comes in.
A 529 savings plan, also called a qualified tuition program, is a type of savings and investment account that is exempt from federal taxes. The money put into such an account may be used to help fund the postsecondary education of a single beneficiary; parents hoping to help pay for education for multiple children will need to open multiple accounts. In addition to being federal tax exempt, many states also offer a tax deduction to people who contribute to 529 plans.
While anyone over the age of 18 can open a 529 account, it typically makes the most sense for parents or grandparents to open an account shortly after the birth of each (grand)child, specifying that child as the beneficiary of the account. Parents can then contribute to the account each year of their child’s childhood, giving the investments 18 years to grow before money need be taken out. An adult who wants to return to college later in life may also benefit from opening a 529 account and listing themself as the beneficiary.
Should the beneficiary of a 529 savings plan die or not need the money, the owner of the account can change the beneficiary to another of the beneficiary’s relatives without any penalty. If the account owner were to die, there’s no penalty to name a new owner. There are penalties, however, if any money is removed and not applied toward qualifying educational expenses. Account withdrawals in this case will be subject to both state and federal taxes, and a 10% penalty will be applied to all earnings.
There are two types of 529 savings plans: prepaid tuition plans and education savings plans. Each state and Washington DC sponsor at least one of the 529 plans, while a group of private postsecondary institutions also sponsor a prepaid tuition plan.
Prepaid Tuition Plans
Prepaid tuition plans are often sponsored by the state. They allow the owner of the 529 savings plan to purchase “credits” at participating institutions that will help pay for tuition for the beneficiary when the time comes. Credits are purchased at the current price of tuition, allowing account owners to lock in cheaper rates than will be available by the time the beneficiary starts school.
These credits typically cannot be applied to room and board costs or mandatory fees and must be used at certain postsecondary schools (often in-state, public schools). For example, in Virginia, parents can purchase semesters of college; each semester they purchase will cover one semester of tuition at a public, four-year college or university in Virginia or 2.6 semesters of tuition at a public, two-year college in Virginia.
While these plans are beneficial for parents who can guarantee that their child will attend an in-state college, they aren’t much use for parents who want their child to have flexibility in their college options. If the beneficiary chooses to attend an ineligible school, the money may applied toward tuition as a fraction of what was put into the account. Furthermore, these types of plans often have residency requirements, though these vary by state. If you open a prepaid tuition plan in Virginia, for example, and then move out of the state—meaning your child is no longer eligible for in-state tuition—you will have to pay the difference between in- and out-of-state tuition.
Education Savings Plans
An education savings plan allows the owner of the account to save money for the beneficiary’s future education at any qualified institution, including colleges, universities, vocational schools, community colleges, and other postsecondary institutions that are accredited and participate in a federal student aid program. This money can be applied to tuition, room and board, books, and mandatory fees and isn’t limited to postsecondary schools—parents wishing to send their child to a primary or secondary school that charges tuition may withdraw up to $10,000 per year.
An education savings plan is an investment account, so there is a certain amount of risk involved. As with any investments, the market can change on a day-to-day basis, meaning that some days, the account will grow, but other days, the account might shrink. Typically, when the beneficiary is young, the investments are more risky (with the higher risk, higher reward mentality), but as they get older and closer to college-age, the investments become more conservative (lower risk, lower reward). Depending on the market while your child is growing up, you could make or lose money overall. However, all earnings are tax-free.
The Fine Print
Limits: Each state limits the total amount of money you can contribute to each beneficiary through a 529 savings plan. Typically, these limits are between $200,000 and $500,000. Once the limit for each beneficiary is reached, regardless of who is contributing money (for example, if a parent and a grandparent open multiple 529 savings plans for the same beneficiary), the savings plan will not accept additional payments.
Fees: Fees lower your returns, but may be offset by tax deductions if they’re offered in your state. Unfortunately, you’ll be hard pressed to find a 529 savings plan that doesn’t charge any fees at all. Prepaid tuition plans may charge an application fee, while education savings plans may charge an application fee, an advisor fee, a maintenance fee, and an asset management fee. You may find that some programs offer fee waivers as incentives. Read the fine print!
Tax Deductions: Many states offer tax incentives to individuals who contribute to 529 savings plans, but this depends on the state. Some states, including Texas and Tennessee, have no state income tax, so there would be no applicable deduction. Others may have income tax and not offer a deduction. Still others may offer tax benefits even if you don’t choose an in-state 529 plan. Read up on your state’s tax laws (you’ll often find the relevant ones on your state’s 529 savings plan website) to learn more.
When choosing a 529 savings plan for your child, grandchild, or another loved one, make sure that you thoroughly investigate all of the options that are available in your state, and maybe some that are sponsored by other states. This research will ensure that you make the right choice for each beneficiary, while maximizing your rate of return and tax benefits. For more information, see Chapter 8: Qualified Tuition Program in this document.