Why 529 Plans Are a Great Way to Save for Qualified College Expenses

Grow your earnings and take withdrawals free of federal taxes

College student studying

 Cavan Images/Getty Images

In its most recent survey of college pricing, the College Board reports that for the 2018–2019 academic year, the average cost of tuition and fees was $35,830 at private colleges, $10,230 for state residents at public colleges, and $26,290 for out-of-state residents attending public universities.

These numbers are in today’s dollars, so if you recently had a baby and you’re looking at college costs that are 18 years away, those prices are going to increase significantly.

With all of ​life's hefty expenses, it's easy to put off education funding, but it's not a good idea. Most Americans will need to save for a long time to have enough to cover four years of college. If you're unsure where or how to begin, a great place to start is by looking into a 529 plan.

What Is a 529 Plan?

529 plans date back to 1986 and have become a widely used investment vehicle for saving for college. What makes the plan so attractive is that, while contributions aren’t deductible, earnings in a 529 plan will grow federal tax-free and will not be taxed when the money is taken out for qualified education expenses. In addition to the federal tax break, there are currently 34 states including the District of Columbia that offer full or partial state tax deductions for contributions to a 529 plan.

There are two types of 529 plans: the college savings plan and the prepaid tuition plan. Here are some of the most important highlights of each plan:

College Savings Plan

  • This plan allows you to build an education fund within an individual investment account. The money you contribute is invested in one or more specific investment portfolios that consist of a mix of investments chosen and managed by the plan’s designated money manager.
  • Funds can be used to pay for qualified expenses at any college accredited by the U.S. Department of Education. This includes undergraduate colleges, graduate and professional schools, two-year colleges, and technical and trade schools. Certain foreign colleges and universities are also included.
  • The plan manager will charge you a fee for administering your account and pass along investment expenses.
  • When applying for financial aid, the plan is generally considered the parent’s/grandparent’s asset.
  • Funds in a college savings plan can be used for graduate school.
  • Qualified expenses are not restricted to tuition and fees—room and board are included, too.
  • Choice of schools does not affect investment return.
  • These plans are not state guaranteed.

Prepaid Tuition

  • This allows you to purchase tuition now for use in the future. There are two ways to do this: through a contract plan or a unit plan.
  • A contract plan promises to cover a predetermined amount of tuition expenses in the future, in exchange for a lump sum or periodic contributions.
  • With a unit plan, you purchase a certain percentage of units or credits and the plan guarantees that whatever the percentage of college costs such units cover now, the same percentage will be covered in the future.
  • Prepaid plans typically charge a flat enrollment fee and, usually, there are not any ongoing charges.
  • When applying for financial aid, the plan is generally considered the parent’s/grandparent’s asset.
  • Specified enrollment (limited).
  • Might be limited to undergraduate school.
  • Generally restricted to tuition and mandatory fees (not room and board).
  • May restrict out-of-state costs and, if less than in-state costs, will not return the difference.

Some Pros and Cons of 529 Plans

There's plenty to consider with a 529 plan, and it can be a useful savings tool and a good addition to your financial planning strategy. However, the plan does have a few limitations, and it's worth knowing the pros and cons.

Pros of a 529 Plan:

  • The "Independent 529 Plan," an updated version of the Prepaid Tuition plan, lets you buy tuition at a discount ahead of time for schools in a 250-member consortium that includes Stanford, Princeton, and Vanderbilt universities.
  • Since 2002, the federal has government stopped assessing income tax on the difference between the value of the account at redemption over your initial investment.
  • You can put away as much as $250,000 into a 529 account, which makes them an investment of choice because they carry no restrictions on income.
  • Since the account can accept larger-than-usual financial gifts, it can help grandparents who have estate-planning issues.
  • The money in your 529 account grows tax-deferred, and you don't have to pay federal income tax when using the funds for qualified education purposes.
  • Account withdrawals don't count as income for either the student or the parent, and so don't affect calculations for financial aid.
  • The plan can be transferred to another family member if your child decides to skip college and do their own thing.

Cons of a 529 Plan:

  • A 529 is less flexible than Coverdell plans because it doesn't cover K-12 expenses.
  • If you use a 529 prepaid tuition option, you'll have to pay any difference in tuition if your child decides to go to an out-of-state or private school. In some cases, if your child doesn't get accepted into a state school, you can use the funds for community college tuition, put it into a regular 529 account, or transfer it to a relative, but in this case, the money can only pay tuition, and not room, board, or any other college fees.
  • 529 plans have been notorious for having inconsistently disclosed fees, although this is being remedied.
  • You can't transfer stock into the plan; it only accepts cash and has a short list of funds available to invest in.

Alternatives to 529 Plans

If, after reviewing 529 plans, you've decided that they don't work for you, take comfort in the fact that plenty of other options exist. You can use any of the following vehicles to put money aside for education, although each has its own benefits and limitations.

  • Coverdell Education Savings Account, which can also be used for K-12 expenses
  • A trust to control access to the money
  • A custodial account in the name of the minor child
  • A Roth IRA, which can be accessed penalty-free at any time
  • Cash-value life insurance, if purchased early in the child's life and used as a loan that may or may not be repaid (unpaid loans reduce the death benefit)

Gifting to a 529 Plan

Normally, an individual can give another individual only $14,000 a year without incurring gift taxes. However, under Internal Revenue Code Section 529, an individual can gift up to 5 years of the annual $14,000 exemptions at once when contributing a child’s post-secondary education. This is a great bonus for anyone who wants to gift in a lump sum.

How to Find the Right Plan

Another bonus associated with 529 plans is that you aren’t restricted to using the plan in the state in which you reside. You will want to look for a plan that meets your objectives and goals and do your due diligence on the plan itself and the fund managers. Here is a great 529 plan locator.

Bottom Line

Are you concerned about how you are going to foot the huge college bills down the road? Don't put off until tomorrow what you can do today, and start investing in a 529 plan.