When you’re in the diaper-and-bottle phase of parenthood, saving for college tuition probably isn’t a priority. But maybe it should be.
Given the rate at which college tuition is rising, a four-year public college will likely cost close to $200,000 in 18 years. With this high price tag, the earlier parents start saving, the better.
A 529 college savings account can make this significantly easier, as it offers a range of tax advantages to lighten the load of educational expenses. Let’s explore what a 529 college savings plan is, how it works, and some considerations if you’re thinking about setting one up.
What Is a 529 College Savings Plan, and How Does it Work?
A 529 plan is a specialized investment account designed to help families save for higher education expenses. Named after Section 529 of the Internal Revenue Code (IRC), these plans are offered by states, educational institutions, or state agencies.
The way these plans work depends on the type of plan you’re using:
- Prepaid tuition plan
- Education savings plan
With prepaid tuition plans, you can purchase credits or units at participating colleges or universities at current tuition rates, shielding you from future tuition increases. However, it’s important to note that only nine states currently offer this option: Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, and Washington.
Further, if you live in one of these states and plan to use this option, your beneficiary must attend an in-state college or university, and you can't use the money to pay for any other expenses. If you don’t live in one of these states, there is a national prepaid tuition plan option for private schools. However, to use this option, you would be limited to the member schools that accept this plan.
Education savings plans, meanwhile, function like traditional investment accounts. The money you save can be invested in a range of vehicles, such as mutual funds or Exchange-Traded Funds (ETFs). Additionally, these savings can grow tax-free. As an added bonus, withdrawals are not taxed at the federal level, as long as the money is used for qualified educational expenses and you report all 529 spending to the Internal Revenue Service (IRS).
Each state offers its own version of these plans, with different benefits and contribution limits. The cost to open a plan is usually low or non-existent, depending on the state and the type of plan. In some cases, there might be a minimal initial contribution requirement.
Before deciding on a 529 plan, it makes sense to compare various state plans to determine which one is most suitable for your needs.
Is a 529 the Best Type of College Savings Account?
While 529 plans are among the most popular choices for education funding, there are others. Deciding which one is best for you hinges on your unique financial goals and circumstances.
For instance, while an Individual Retirement Account (IRA) is primarily designed for retirement savings, Roth IRAs allow for penalty-free withdrawals for qualified educational expenses. Before going this route, however, keep in mind that this approach essentially means you’d be depleting your retirement fund to pay for your child’s education, which isn’t ideal.
Like a 529, a Coverdell Education Savings Account (ESA) allows you to save for qualified education expenses tax-free, and it can be used for K-12 expenses as well. While this is great for parents who choose to send their children to a private elementary or high school, the catch is that contributions are limited to $2,000 per year per beneficiary.
Pros and Cons of 529 College Savings Plans
There’s a reason there are 15.81 million open 529 plans right now: they offer a host of benefits. However, like many programs, 529 plans may not be the best fit for everyone. Here are some of the most significant pros and cons:
Pros
- Tax advantages: One of the greatest benefits of a 529 plan is its tax-free growth. Earnings on 529 investments are not subject to federal taxes, and withdrawals for qualified educational expenses are also tax-free.
- Flexible ownership: With a 529 account, the money saved can be used for anyone you choose. So, if one of your children receives a scholarship, the money saved can go to another child, or even your own education if you opt to pursue higher education in the future.
- High contribution limits: Most 529 plans have high contribution limits, typically $300,000 or more, which gives you room to accumulate significant savings over time.
Cons
- Limited investment options: While 529 plans offer multiple investment choices, they are still limited to the preselected options provided by the plan.
- Penalties for non-qualified withdrawals: If funds are used for non-qualified expenses, the earnings portion of the withdrawal may be subject to federal income tax and an additional 10% penalty.
- A tax-free cap: 529 plans don’t have annual contribution limits. There are aggregate lifetime limits per state and per beneficiary, but these are generally pretty high and in place to avoid overfunding. Contributions are considered “completed gifts” for tax purposes. Accordingly, annual contributions that exceed $17,000 (or $34,000 for married couple) in 2023 may count against your lifetime estate and gift tax exemption amount (which is $12.92 million in 2023). There is a special rule called “front loading” or “super funding” that allows you to make a lump sum contribution of up to five years of annual gift exclusion amounts (2023: $17,000 * 5 = $85,000 or $170,000 for MFJ) in one calendar year without triggering any gift taxes or counting towards your lifetime gift and estate tax exemption. If you do frontload, you’ll need to file the gift tax return for the five-year period to indicate it is being spread out over that time period.
Planning for the Future
A 529 college savings plan can offer excellent opportunities to save for your children's future education, all while enabling you to benefit from tax advantages and investment growth. If you’re starting to save a child’s college education, talk to your financial advisor about setting up a plan that works for you.
This information is not intended to be a substitute for individualized legal advice. Please consult your legal advisor regarding your specific situation.
