Next to saving for retirement, your biggest financial challenge is probably saving for your kid’s college education. How do know how much to save? How much will a college education cost? What if you save all of this money and then she decides to tour Europe instead of going to college? Can you cash in the account and take that dream vacation you and your spouse have been thinking about? That depends on how and where you’ve stashed the money. Luckily, today there are several flexible ways to save for future tuition costs, including opening a 529 college savings plan.
A 529 college savings plan is a very simple way to save money for your kids’ (or anyone else’s) college education. The benefits are tremendous. Here are some of the heavy hitters:
- You pay no federal taxes on the account’s earnings, and there may be state tax benefits as well.
- The child doesn’t have control of or access to the account — you do.
- If the child doesn’t want to go to college, you can roll the account over to another family member.
- Anyone can contribute to the account.
- There are no income limitations that might make you ineligible for an account.
- Most states have no age limit for when the money has to be used.
The Cost of College
College is expensive, and it keeps getting more expensive. It’s tough to predict what college is going to cost in 10 or 15 years, because the cost can’t keep spiraling upward endlessly. But the best way to get an idea of what college costs will look like in the future is to look at the real numbers. What does college cost today, and how much have those costs risen in the last ten years?
Based on U.S. Department of Education data, the Institute of Education Sciences reported that costs for undergraduate tuition, room and board at a public college or university during the 2010–11 academic year totaled $13,600. Of course, those costs skyrocket if you go private: Prepare to spend about $36,300 at private not-for-profit institutions, and $23,500 at private for-profit institutions. These costs have only risen in the last few years: The Institute of Education Sciences also reports that “between 2000–01 and 2010–11, prices for undergraduate tuition, room, and board at public institutions rose 42 percent, and prices at private not-for-profit institutions rose 31 percent, after adjustment for inflation. The inflation-adjusted price for undergraduate tuition, room, and board at private for-profit institutions was 5 percent higher in 2010–11 than in 2000–01.In other words, saving money now for college is not a bad idea, and a 529 plan might be a good way to do it.
The 529 Plan
The 529 Plan (named for Section 529 of the IRS tax code) is a savings plan for college education. There are two types of 529 plan:
- One option lets you prepay tuition at a qualified educational institution at current tuition rates.
- The other option lets you invest money in a tax-deferred account that will later be used to pay for education at future tuition rates.
Either option lets you earn interest on your investment. Pre-paid tuition plans have some serious drawbacks, mainly because they’re more restrictive with who can participate and how the money can be used. For that reason, we’re going to focus this article on the more flexible 529 investment plans.
A 529 plan is a state-sponsored investment program. That is, the state sets up the plan with an asset management company of its choice, and you open a 529 account with that asset management company according to the state’s predetermined plan features. You’re the owner of the account, and the child for whom the account is set up is the beneficiary. You won’t deal directly with the state, but rather with the asset management/investment company. Like any other investment, a 529 is subject to market risk – the state doesn’t guarantee your money.
Benefit: Tax-Exempt Earnings
All of a 529 account’s earnings are exempt from federal taxes when they’re withdrawn if they are used for qualified education expenses. This means that, unlike the taxes you have to pay on earnings from regular stock investments, you won’t pay any taxes on 529 account earnings unless you end up using the money for something other than higher education. Earnings are currently tax-deferred in most states, as well.
A break on the earnings tax isn’t the only tax advantage, either. Although your contributions aren’t pre-tax (you pay state and federal tax on the money you put into the account), there are some states that let you deduct a portion of your contributions from your state taxes.
One of the nice things about a 529 plan is that qualified education expenses are very broadly defined (much more liberally than with a prepaid tuition plan). Eligible expenses include tuition, room and board, fees, books and even computers. If you need it to study, you can probably use the 529 plan to purchase it.
Unlike custodial accounts or Education Savings Accounts (ESAs, formerly Education IRAs), the beneficiary doesn’t gain control of the money at a specific age (usually 18 or 21 for those types of accounts). The account owner always has control of the money. You don’t have to worry that your child will grow up and spend the money frivolously.
There are no restrictions on who can open an account for whom. You can open an account for your child, a friend’s child, a relative, the paper boy, or even yourself. 529 plans have no age restrictions either, so an adult could open one to pay for some classes next year.
If it turns out that the beneficiary won’t be using the money in the 529, there’s a lot of flexibility in how you can ultimately use the money. You can change the beneficiary, or you can roll the funds over into a different qualified investment product. There may be additional fees, depending on what you choose, and some account changes are limited to once per year.
You can withdraw the money for non-education purposes if absolutely necessary, but you’ll have to pay the tax on the earnings, plus a 10 percent federal tax penalty.
As we mentioned on the last page, custodial accounts (also known as Education Savings Accounts or ESAs) are a bit more rigidly structured than most 529 accounts. Here’s one major example: Did you know you can’t contribute to an ESA if you make more than $95,000 per year ($190,000 for married couples, as of 2012 ? Unlike ESAs, your income doesn’t affect your eligibility to open a 529 account. In addition, most states don’t limit contributions either, which is crucial for those who want to pass money to their children or grandchildren for school.
Contributions to 529 plans also qualify for the $14,000 ($28,000 for married couples in 2013) annual gift tax exclusion . You can also contribute up to five years of gifts during the first year. This is a great benefit in situations where inheritance money enters the picture.
The contribution limits (the maximum you can put into the account) are very generous in most states, typically above $200,000. At the other end of the spectrum, you can contribute as little as $25 to $50 per month.
Most states’ 529 plans are managed by investment companies such as TIAA-CREF, Vanguard and Fidelity. The number and types of investment options vary by state, and once you select your option you can’t change it. You can, however, roll your money over into another state’s plan if you’re not happy with your chosen investment option. There is no penalty to roll the money over into another state’s plan, and you can do it once every 12 months.
Many plans are also offering investment choices that are age-based. This means that if you’re starting early, perhaps when your child is age one to three, the investments can begin aggressively in stocks then gradually shift to bonds and money market accounts as your child gets closer to college age. Some state plans offer several levels of options for aggressive, moderate and conservative investments.
If you can’t reach the risk level you want in one plan, you can always open a second 529 account in the same or another state. You can have as many accounts as you want and can also contribute to both a 529 plan and an ESA. That way, you can diversify your investments in the event that the plan doesn’t offer the investment mix you would like.