While there are many ways to save for college, one of the best ways is through a 529 savings plan. These plans are specifically designed to allow tax-free savings for education expenses.
With a 529 plan, there is no tax on gains made as investments grow. Money is later withdrawn tax-free for use on education expenses, ranging from tuition to buying a laptop. Use the funds for something else, and you’ll owe taxes and penalties.
Here’s a look at how 529 plans work and why they’re a valuable tool in saving for college.
Every state has at least one 529 plan available. States design their own plans, so terms vary from state to state. But you don’t have to invest in your state’s plan. You retain control of the accounts, and anyone can contribute to an account, from relatives to total strangers. People with large estates may be able to substantially reduce the size of their estate and the estate’s future tax burden by making gifts to a 529 plan.
Keeping the 529 plan in your own name is advantageous when it’s time to apply for financial aid. Assets in a 529 plan in a sponsor’s name will only be assessed at 5.64 percent of their total value in determining what the family will be expected to pay. The tax-free withdrawals are not counted as income toward the student’s financial aid for the following year, either.
Here are some more 529 facts:
- The money doesn’t have to be spent at an in-state school. Most 529 plans are valid at many colleges and universities across the country.
- Many major investment firms offer their own 529 college savings plans. Individual learning institutions or groups of colleges may also offer a type of 529 plan.
- Money in a 529 plan can be transferred from one child to another without penalty.
- In a state with state income tax, you may derive state tax benefits from having a 529 plan in addition to the federal tax breaks.
- You can make substantial deposits in 529 plans, $300,000 or more in some state plans, potentially reducing your income tax burden.
Types of 529 Plans
There are two basic types of 529 plans: savings plans and prepaid plans. Savings plans work much like 401(k) retirement plans, investing primarily in mutual funds and putting the money at risk for losses that accountholders bear. The money is professionally managed, and investors need not make investment decisions.
In a prepaid plan, investors purchase units of future education at today’s prices with a guarantee that the units will pay for an equal amount of education in the future. The burden then falls on the institution that offers the plan to make investment returns that outstrip rising education costs. The unit price changes from year to year to account for increased education costs.
In either case, the earlier donors start a 529 college account, the more gains they will likely see by the time a child is ready to use the money. You can invest in a 529 plan directly or through a financial advisor.
Business reporter Carol Tice contributes to several national and regional business publications.