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Saving for College: Is a 529 College Saving Plan Right for You?

Saving for College: Is a 529 College Saving Plan Right for You?

Can you handle the cost of college?

The average student borrower takes 20 years to pay off their debt, which often translates to delaying a home purchase, starting a family, and living the good life. At the same time, the cost of in-state tuition at public colleges, typically the cheapest university education available to students, rose by 211% over the past 20 years.

Even worse, federal loan programs fail to provide enough aid to all students. As a result, private loans—often carrying higher interest rates and fewer borrower protections—have increased by 7x over the past 10 years.

Fortunately, however, there is a highly-effective tool available to parents who want to help their children pursue the education they dream of: A 529 College Saving Plan. These plans are simple, straightforward, and can be set up quickly and within the comfort of your own home. In this article, we’ll discuss how a 529 plan works, review the advantages that a 529 plan offers, and demonstrate just how effective they can be.

What is a 529 College Saving Plan?

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. Broadly speaking, there are two types of 529 plans: prepaid tuition plans and education savings plans.

Prepaid Tuition Plans

Prepaid tuition plans allow savers to purchase courses and credits at today’s tuition rates at eligible colleges or universities, helping them manage future tuition costs. However, savers cannot generally use prepaid tuition plans to pay for other educational expenses, such as room and board.

Education Savings Plans

These plans let a saver open an investment account to save for future qualified higher education expenses, including tuition, mandatory fees and room and board. Funds from these plans can be used at almost any US college or university, and even some non-US schools, too.

Although created by federal legislation, 529 plans are administered by the 50 states and the District of Columbia. Notably, only nine states currently offer prepaid tuition plans, so the vast majority of 529 plans are education savings plans.

How Does a 529 Plan Work?

A 529 plan works similarly to a 401(k), but for education instead of retirement. As a tax-advantaged plan, participants can defer compensation from their paycheck into a 529 account without paying state or federal taxes on their contribution. From there, a saver can construct an investment portfolio across different asset classes and vehicles, including mutual funds, exchange traded funds, or the popular target date funds. While within the 529 account, these investments grow tax-free and can be withdrawn tax-free to pay for qualified expenses, meaning each dollar goes a much longer way than normal.

Importantly, while there are no annual contribution limits for 529 plans, contributions made to them are considered “gifts” for tax purposes. Also, while all 529 plans are sponsored by state governments, most states do not have a residency requirement for the saver, meaning you can generally open an account in a state other than your own.

What Can You Spend 529 Plan Funds On?

With a prepaid tuition plan, you are mostly limited to spending funds on courses and credits. However, with an education savings plan, there is significantly more flexibility in what you spend your funds on. Some of the non-tuition expenditures you can make include:

  • Room and board, including off-campus if the expense is within the school’s published cost of attendance
  • Fees, books, supplies, and equipment
  • Computers, peripherals, software, and the cost of internet access
  • Expenses related to students with special needs
  • Up to $10,000 per year tuition at a primary or secondary school
  • …and much more!

The flexibility offered by 529 education savings plans gives parents the ability to help their children pursue their dreams, no matter where it may take them.

Fees Associated with 529 College Saving Plans

Fees and expenses can vary greatly depending on the type of plan, whether it is sold direct or by a broker, how actively it is managed, and the underlying investments. Just some of the fees applicable to education savings plans are:

  • Enrollment or Application Fees
  • Annual Account Maintenance Fees
  • Program Management Fees
  • Asset Management Fees

Some of these fees are collected by the state sponsor of the plan and some are collected by the plan manager. When selecting a plan, it is important to choose an investment that meets your goals while minimizing the fees you pay, preventing you from overpaying for a service you could get cheaper elsewhere.

Tips for Saving on 529 Plan Fees

There are a number of ways to minimize your plan fees, depending on the investments available to you and the structure of your plan. Some of these tips include:

  • Participating in an automatic contribution plan
  • Maintaining a large account balance to reduce administrative fees
  • Participating in a state-sponsored plan in your state of residence

Beyond these, there are a number of other strategies that can help you save on fees. For example, the SEC states that, “many states offer direct-sold education savings plans in which savers can invest without paying additional broker-charged fees.”

What Do I Need to Consider Before Setting Up a 529?

As with any potential investment, the value of a 529 plan is dependent upon your unique circumstances, goals, and financial situation. That said, there are a number of common benefits and drawbacks that you should take into consideration:

529 College Saving Plans: Advantages

State and Federal Tax Benefits

The investments within your 529 grow and can be withdrawn tax-free, saving you money on capital gains taxes. Similarly, many states offer a state income tax deduction or state income tax credit for 529 plan contributions.

Low Maintenance & Easy Setup

529 plans can be set up online and do not have minimum income or asset requirements. Additionally, savers can sign up for an automatic investment plan that makes deductions from their bank account ensuring they never miss a contribution.

Favorable for Financial Aid Applicants

Distributions from 529 accounts are not counted as income on the Free Application for Federal Student Aid (FAFSA), and 529 plans are reported as a parental asset and have a relatively minimal effect on financial aid eligibility.

Flexibility

As mentioned previously, 529 plan funds can be spent on a wide range of education-related expenses and can be used at almost all colleges, universities, trade schools, and primary and secondary schools.

529 College Saving Plans: Disadvantages

Penalty for Non-Qualified Withdrawals

Funds withdrawn from a 529 plan that are not spent on a qualifying expense are subject to income tax and a 10% penalty on the investment returns generated by the plan.

Limited Investment Choices

The owner of a 529 account can only direct their contributions toward one of the investment options offered by their plan. While plans offer a variety of investment options including target date funds, those who want to completely customize their portfolio might desire additional options for their plans.

Fees Associated With 529 Plans

Though the tax savings from a 529 plan generally outweigh any of the associated fees, it’s important to be mindful of them when selecting a plan. Research the plans available to you and find a low-cost option that meets your family’s unique needs.

Ownership Rules

The owner of the 529 account, not the intended beneficiary, has legal control over the money in the account. This could be an issue if a parent is depending on a grandparent or a relative’s 529 plan to help pay for their child’s education.

Conclusion: Is a 529 College Saving Plan Right For You?

A 529 plan is a powerful tool for parents, grandparents, or anyone else to help a loved one pay for the cost of higher education. When deciding to open a 529 plan, savers should understand their financial situation, know the cost trends within higher education, and have an open conversation with their partner about their family’s goals.