If money is already tight, it can be unsettling to think about trying to save to send your children to college. Fortunately, there are tools to help you, with the most popular way to save called a 529 plan. It’s a savings plan specifically designed for educational expenses and comes with tax benefits.
These benefits allow your money to grow tax free at the federal level. You can withdraw and use the money without being taxed, as long as you use it for qualified educational expenses such as tuition, books, fees or even room and board. The earlier you start a 529 plan, the more time you have for the money to grow and ultimately the more money you will have to help your children pay for school.
What Is a 529 Plan
As mentioned above, a 529 is a savings account intended specifically for educational expenses. You contribute money to the account over the years and can watch it grow tax-free. When the time comes to withdraw money to pay for qualified educational expenses such as tuition, even up to $20,000 annually for tuition for K-12 education , or college textbooks, professional credentialing fees, housing, etc., and you can do so without being taxed. 529 money can even be used to pay up to $10,000 in student loans.
529 savings accounts allow you to allocate your money across a variety of investment options such as mutual funds to help your savings grow and deliver long-term returns. The earlier you start contributing, the more time your money can grow, due the power of compounding.
Compounding allows you to earn even more money by receiving interest on your interest. For example, if you contribute $200 a month to your 529 from the time your child is born until college, so 18 years, and the money grows at an annual rate of 6%, you would have about $75,000 to use by the time your child graduate’s high school.
Key Factors to Consider When Shopping for a 529 Plan
Tax Benefits
One of the biggest advantages of a 529 plan are the tax benefits, with the single best benefit being that earnings can grow free from federal taxes. Even withdrawals can be federally tax exempt, as long as they are used for qualified educational expenses. This means that as long as you use the money for expenses deemed as “qualified” such as tuition, room and board, books and fees, all the money you earn is yours to use for these items and free of any federal taxes.
With respect to state taxes, that can vary depending on where you live. Some states will offer tax incentives such as credits for contributions or deductions to 529 plans that are located in-state. For example, if you live in New York and have an in-state plan, you can claim a deduction on your state taxes for contributions to the plan up to $5,000 if filing individually, or $10,000 if filing jointly.
Or if you live in Utah, their my529 plan also allows for tax credits on contributions. Not all states have these benefits. Before you open a plan, you should look at what your state offers to ensure that the benefits outweigh any other detracting factors like fees or investment options.
Fees and Costs
529 plans aren’t free, there are fees associated with these plans that can diminish your overall savings over time. It’s important to factor in these fees when choosing a plan. Typical fees can include, but are not limited to, enrollment fees, annual account maintenance fees, and asset management fees. Individually these fees might seem small, but they can add up over time and potentially have an impact on your overall savings. Look for lower fees because these amount to more money for your children’s education in the future.
When evaluating fees, specifically look for plans with transparent fee structures so you can easily compare the expense ratios of their various investment options. Variations in fees, even seemingly small ones like the difference between 0.20% and 0.50% can potentially result in the loss of thousands of dollars of savings by the time your children head off to school.
Investment Options
While considered a savings plan, 529 plans allow you to invest your contributions which in turn, gives your money an even greater chance to grow, as opposed to just offering simple interest. Your investment choices can be tailored to each child given their age and your risk tolerance.
A popular choice for many parents are age-based portfolios which automatically adjust your distributions across stocks and bonds, moving from a more aggressive position to a more conservative position as your child gets closer to college. For those that want to have more control, there are options that allow you to modify your investment mix as you see fit.
Tailoring your investments based on the time you have until your child leaves for college can be a smart strategy. If you have more than a decade before you will need the money, you may choose to be more aggressive and try to grow your money faster. If college is just a year or so away, you might want to pull back and take a more conservative approach ensuring the funds will be there when you need them.
State-Specific Plans vs. Out-of-State Plans
It can be wise to choose a 529 plan offered by your home state, even more so if it comes with tax deductions, scholarships or other incentives only available to in-state residents. That said, there can be instances when an out-of-state plan might be more suitable. Depending on what’s available in your state, an out-of-state plan might offer lower fees, better investment options or simply perform better overall making those benefits outweigh the what’s available with your in-state plans.
Contribution Limits and Rules
There are limits to how much you can contribute each year to your 529 plan and these limits can vary by state. In most cases, you can contribute up to $19,000 per year, per child, without incurring gift tax because this amount is equal to the maximum allowed for the annual gift tax exclusion. Be sure to check each year what the maximum allowable contribution is, as it can change.
If you happen to come into a large sum of cash for whatever reason and want to put towards your child’s 529 plan, the IRS allows something called “superfunding” which is a single lump-sum contribution up to 5 years’ worth of the annual limit in a single year. There are also lifetime limits which will vary by state but essentially can range between $235,000 - $597,000. You should know your annual and lifetime limits so you can plan accordingly.
If you choose to open a 529 plan, take the time to compare your options carefully. This will help you save on costs and maximize your savings. Here are some tips:
- Use online tools. Take advantage of websites like SavingforCollege.com with tools that offer side-by-side comparisons of different 529 plans. These types of tools can help you quickly sift through the details of each plan and find the one that best aligns with your individual needs.
- Use a checklist to evaluate the plans. A checklist can help you narrow down the finalists in your search. When creating your checklist be sure to include factors like state tax benefits (if applicable), fees, investment options, and flexibility. This will allow you to quickly assess the benefits vs the costs of each plan and will help you stay organized so you can make an informed decision.
- Some common mistakes. It can be easy to be swayed by the tax benefits but be sure to evaluate all aspects of the plan. Tax advantages are great but don’t overlook the potential costs of high fees. Balancing all the factors ensures you’re not sacrificing long-term growth potential for short-term perks.
Steps to Open and Manage a 529 Plan
When you decide to open a 529 plan the actual process of opening the account is simple.
Select the Right Plan
Do your homework and research all your available options, both in-state and out-of-state to find the plan that best fits your needs. Be sure to compare every factor against each other and determine which benefits you value the most and which costs you want avoid. Ultimately you want a plan that going to perform the best for you long-term so that you can earn the most possible money for your child for college.
Understand Account Ownership
Generally, as the parent opening the account you will be the account owner with your child as the beneficiary. You will be the one to control the plan, and its assets. You will still be the owner of the plan even if your child doesn’t go to college.
Open the Account
In most cases when you are ready to open the account you will be able to do so online. However, if you have any questions, you can always call the plans customer service to help with the enrollment process. To complete the process, you’ll need some basic information, such as you and your child’s social security numbers and other basic personal info.
Fund the Account
One the account is created you’ll want to fund it with an initial deposit. Most plans allow for small deposits to help get you started, but if you can you’ll want to regularly add money to the account. You can do that manually with one-time deposits or automatically with recurring contributions at whatever interval works best for you.
Managing the Plan
Opening the account is only the beginning. Properly managing your 529 plan ensures it grows over time and meets your savings goals.
Make Regular Contributions
Consistency is key. Even small, regular contributions add up significantly over the years, thanks to the power of compound growth. Setting up automatic deposits from your bank account can make this process effortless and keep you on track.
Review Investment Performance
At least once a year, take the time to review how your investments are performing. If the market changes or your child gets closer to college age, you might want to shift to more conservative investment options. Many plans offer age-based portfolios that adjust automatically.
Track Your Progress
Use online tools or statements from the plan to monitor how close you are to your financial goals. Address any gaps early so you can adjust your strategy if needed.
Maximizing Tax Benefits
One of the biggest advantages of a 529 plan is the tax relief it offers.
Contribute Early and Often
The earlier you start, the more time your contributions have to grow tax-free. Even small amounts added when your child is young can make a big impact by the time they reach college.
Time Withdrawals Strategically
When it’s time to use the funds, make sure you align distributions with qualified education expenses, such as tuition, books, and room and board. Doing this ensures that the withdrawals remain tax-free.
Take Advantage of State Tax Deductions
If your state offers income tax deductions or credits for 529 contributions, factor this into your plan. Often, contributing up to the maximum deductible amount each year provides the most benefit.
