Why is a 529 college savings plan important?
Because college can come with a hefty price tag. The average published tuition and fee price for full-time in-state students at public four-year colleges and universities is $10,440 in 2019-20, $230 higher than it was in 2018-19, according to the College Board. Prices for out-of-state enrollment and private institutions are higher still.
A 529 plan allows you to save for that coming bill in a tax-advantaged way and avoid interest on loans.
What is a 529 plan?
Today, every state in the U.S. offers at least one 529 plan. While the way plans are structured may vary, they are generally categorized two ways:
Savings: Typically provided by the state, a qualified college savings plan offers a lot of flexibility. There are no income requirements or age limits to open the plan. By contrast, another college savings vehicle, Coverdell ESAs, have income and phase-out limits that leave high-earning taxpayers ineligible for tax advantages.
Much like a 401(k) plan or traditional IRA, pre-tax contributions to savings-based 529 plans typically go into a portfolio of stock and bond offerings. The range of options depends on the individual plan.
The specific rules for 529 college savings plans vary from state to state. Generally, you may open an account in any state you'd like, regardless of where you live. Plus, anyone can contribute to the 529, from parents and grandparents to other relatives and friends. You can even open an account for yourself if you want to go back to school.
Each state sets the lifetime contribution limit for its respective 529 plan, generally between $100,000 and $270,000. Initial minimum investments can be as low as $25 per month.
Prepaid: These 529 plans provide parents the opportunity to pre-purchase tuition to a specific university or group of universities based on today’s rates. Essentially, these plans are a play against inflation, allowing the purchase of school attendance now in anticipation of higher costs later. Typically administered by states, higher education institutions, or not-for-profit organizations, prepaid tuition plans are not offered everywhere.
It’s possible to use the funds in a prepaid plan to attend a school not in its network, but there might be a penalty depending on the particular 529 plan’s rules.
Whether you choose a college savings or prepaid tuition plan, there’s one important thing to keep in mind: Withdrawals from 529 plans must be used on qualified higher education expenses. So what is considered a qualified expense? (Related: Prepaid versus savings 529 plans)
To gain the maximum advantage of a 529 plan and avoid penalties, you can only spend your college savings funds on qualified higher education expenses. These include:
- Room and board (for students enrolled half-time or more; includes off-campus rent)
- Mandatory fees
- Books and supplies
- Equipment required for enrollment (such as a computer)
Make sure to check the list of qualified expenses at your beneficiary’s institution. They don’t always include items that may seem necessary, like clothes or transportation. Even a computer is not eligible unless the school has a written policy requiring it for attendance. Fortunately, that requirement is becoming more common across the country.
The tax advantages of 529 savings plans are one of the main reasons so many people invest in them. While contributions are made on an after-tax basis, the earnings in a 529 plan grow tax-deferred and withdrawals are free of federal income tax when used for qualified higher education expenses. Some states also offer full- or partial deductions for contributions.
But if you use the money in your 529 account for non-qualified purposes, the earnings portion of the withdrawal will be subject to ordinary federal income tax, plus an additional 10 percent penalty and any applicable state income tax. (Related: Alternative uses for 529 money)
When planning and budgeting for your college savings, remember that qualified expenses are the majority of the cost of college. While everyone’s needs and situations vary, one strategy always applies: Every dollar you save today gets you a little closer to your college-savings goals.
For a list of 529 plans go to savingforcollege.com. To find out more information about a plan you can contact the specific plan directly or contact a financial professional.
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