Saving for your child or grandchild's higher education is one of the most important investments you can make for his or her future. To make saving for college easier, the Qualified Tuition Program or 529 plan was created. Named after section 529 of the Internal Revenue code, it is a federal-income-tax-free savings plan to be used for qualified educational expenses. Many states throughout the country also offer their own versions of the 529 plan; those are administered by state agencies and other organizations.
Two different 529 plans available
Currently, there are two different versions of the 529 plan from which to choose:
- Prepaid tuition plans - These plans allow for the pre-purchase of tuition based on today's interest rates, with money to be disbursed when the beneficiary enters college. Prepaid tuition plans are usually managed by state organizations or by colleges and universities. The funds in prepaid tuition plans can often not be used for room and board at colleges and can't prepay tuition at elementary or secondary schools.
- Savings plans - Most 529 plans are actually savings plans that invest in mutual funds, certificates of deposit, and comparable instruments, and are therefore dependent on the investment return of these assets. The Tax Cuts and Jobs Act (TCJA) expanded the use of 529 education savings plan funds from covering only qualified college expenses to also include eligible private, public, or religious elementary or secondary school expenses. However, it limited the total amount payable for elementary or secondary tuition to $10,000 per year.
At the moment, all fifty states and the District of Columbia offer at least one kind of 529 plan.
Five benefits of a 529 college savings plan
There is a lot to be said for opening a 529 plan for your child's education. Below are a few of the benefits offered by these plans, and how you can best take advantage of them.
- Enjoy federal tax benefits - While you can't take a deduction for contributions to the 529 plan on your federal income tax return, investment returns within the plan grow tax-free. In addition, all distributions made from the plan for qualified higher education costs are also free of federal taxation, provided they are less than or equal to the adjusted qualified education expenses. The IRS Publication 970, "Tax Benefits for Education", explains how to calculate the taxable portion of distributions.
- Your state may offer tax benefits, too - Many states also offer tax breaks in addition to the federal tax benefits mentioned above. The website Savingforcollege.com offers a detailed map of optional state tax plans available to you. Click on your state to discover the tax advantages being offered where you live.
- Easy enrollment and maintenance - Your 529 plan can provide a convenient and hassle-free way to save for college. After choosing the plan that you would like to use, complete your enrollment form and start making contributions. You can even use automatic deposit. Your plan is managed either by your state treasurer's office, or by an investment firm that handles the plan's financial management.
- You control the funds - As the benefactor of the 529 plan, you maintain complete control over the account. This way, you can make sure the money is used as intended for educational purposes, and you decide when and how it is to be spent by your beneficiary. Should circumstances change, some plans will allow you to withdraw all of the money for yourself; however, you will be required to pay income tax and a 10% early withdrawal penalty.
- Flexibility is a plus - Similar to an IRA or 401(k) plan, a 529 plan permits you to move money around to different accounts within the plan. You may even be able to rollover your account into a different state's 529 plan, as long as no rollover has occurred within the past 12 months. Remember, each plan has its own set of rules, so do your research before making changes that could adversely affect your investment.
Alternatives to a 529 plan
While a 529 college savings plans can look inviting on the surface, don't forget that there are other ways to save for your child's college expenses, such as:
- UGMA/UTMA accounts - "Uniform Gifts to Minors Act" (UGMA) and "Uniform Transfers to Minors Act" (UTMA) accounts are investment accounts set up in your child's name, which tend to offer more investment flexibility than a 529 plan. UGMA accounts are restricted to financial assets, such as stocks, annuities, bonds, cash and insurance policies, while UTMA accounts can manage any tangible or intangible asset, such as artworks, real estate, or intellectual property.
Warning: The money in a UGMA or UTMA account is considered your child's money and not your own. Therefore, it can be used for any purpose the beneficiary desires, such as plastic surgery or buying a yurt in Outer Mongolia.
- Coverdell Education Savings Account - Similar to a Roth IRA for educational purposes, the earnings on the account are tax-free if used for qualified education expenses, and the money can be applied to private primary- and secondary-school expenses, as well. Unfortunately, contributions are limited to $2,000 per child per year, and there are penalties for non-qualified withdrawals or if the money is not used by the time your beneficiary turns 30 years old.
There are a number of advantages to investing in a 529 plan for your child's education, not the least of which are the federal and state tax benefits. However, as with all savings plans, it's best to start early while your student is still a toddler to get the biggest financial benefit from your investment.
It's easier to save money for college when your low credit score doesn't make you pay high interest rates. You can check your credit score and read your credit report for free by joining MoneyTips.