Saving for College with a 529 Plan

Nick and Amy knew they wanted to send their two daughters to college, but the college sticker price was daunting. They also knew, however, that they didn’t want their children to be saddled with big student loan payments after graduation. After doing some research, they decided to open 529 accounts for each child. “We probably won’t save enough for full tuition, room, and board, but it’s great to know that every dollar we save now is a dollar our children won’t have to pay back with interest later,” says Amy. Instead, each dollar they save is increasing in value, tax free, in the 529 accounts they established when their girls were toddlers.

 

What Exactly Is a 529 Plan?

A 529 account is named for the section of the IRS tax code that covers qualified tuition plans. Put simply, it’s a way to save money free from federal tax—and often state tax as well. States, investment firms, and educational institutions all offer 529 plans, and there are usually two types to choose from:

 

  • 529 savings plans are more flexible, but they’re also riskier. You choose the funds you want to invest in—usually mutual funds, or the same types of investments offered in 401Ks, IRAs and other long-term investments. To help you manage the risk, many plans offer age-based options that automatically the money you put into the plan in increasingly safer investments as your children get closer to college age.
  • Pre-paid tuition plans allow you to buy in-state tuition credits—usually at public universities—that are “locked in” at today’s prices. Right now, Virginia, Maryland, Massachusetts, Mississippi, Florida, Washington, Michigan, Nevada, Illinois, Pennsylvania and Texas offer prepaid tuition plans. These plans can be a great value, but many more restrictions apply. Your child may be limited to colleges in the state where he or she lives, for example, so if you move after starting the fund you might not get the plan’s full benefits. The window of time for investing is also more limited, and it can be more difficult to transfer your plan to another child.

 

Benefits of 529 Plans

Like we said earlier, you won’t pay federal taxes on the money in your 529 plans, as long as it’s used for education-related costs. There are other benefits as well:

  • You can set up automatic investments to make saving easier. “Sometimes we change the amount, but we do deposit something every month,” Amy notes.
  • 529 plans can apply to vocational schools and graduate schools, as well as colleges and universities. And they aren’t just for children. You can even set one up for yourself.
  • Other people—like grandparents, aunts and uncles—can invest in your 529 account, and they may receive a tax break for doing so. “My mother makes a little investment in our children’s Ohio 529 plans every year,” says Nick. “Since she lives there, she gets a break on her state taxes.”
  • You won’t be tempted to use that money for other expenses, because the penalties for “non-qualified distributions” are stiff.

Scholarships and student loans are important sources of college funding, but they can involve a lot of uncertainty. A 529 plan offers an important source of security. By setting up monthly automatic deposits into a 529 plan, you can create a tidy nest egg for your child’s education after high school.