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

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In its most recent survey of college pricing, College Board reports that for the 2020-21 academic year, the average cost of tuition and fees was $37,650 at private colleges, $10,560 for state residents at public colleges, and $27,020 for out-of-state residents attending public universities.

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

With all of ​life's hefty expenses, it's easy to put off education funding, but that'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, one great place to start is by looking into a 529 plan.

What Is a 529 Plan?

The 529 plans date back to 1986 and have become widely-used investment vehicles for saving for college. What makes these plans so attractive is that, while contributions aren’t deductible, their earnings 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 on earnings, currently 34 states and the District of Columbia offer full or partial state tax deductions for contributions to a 529 plan.

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

College Savings Plans

  • 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, including 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 may charge you a fee for administering your account and will pass along investment expenses.
  • When applying for financial aid, the plan is generally considered the parents' or grandparents' asset.
  • 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 Plans

  • These plans allow you to purchase tuition now for use in the future, through either 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 there may be some ongoing administrative charges.
  • When applying for financial aid, the plan is generally considered the parents' or grandparents' 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 "Private College 529 Plan," an updated version of the Prepaid Tuition plan, lets you buy tuition at a discount ahead of time for schools in a 293-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 and your initial investment.
  • 529 Plans are an investment of choice because there are no restrictions on income. Note that 529 plan limits vary by state/program. (The contribution limit for 529 plans cannot exceed the amount needed to pay for qualified education expenses.)
  • 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, so they 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 a Coverdell plan 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 them into a regular 529 account or transfer them to a relative, but in that case, the money can only pay tuition and not room, board, or any other college fees.
  • You can't transfer stock into the plan; it only accepts cash.

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
  • 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 $15,000 per year without incurring gift taxes. However, an individual can gift up to five years of the annual $15,000 exemptions at once when contributing to 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 them in the state in which you reside. You will want to look for a plan that meets your objectives and goals, and you should 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. Start investing in a 529 plan.