Every parent dreams of sending his or her child to college — but making this dream a reality can often feel like an insurmountable task. The average cost of tuition in the U.S. is on the rise, according to a 2017 report from College Board, and attending college could set your child back tens of thousands of dollars annually.
Fortunately, you have options as a parent. A 529 college savings plan, for example, could help you sock away money for your child's future higher education expenses. Explore the basics of 529 plans, learn how such plans could be used and discover if one could be the right choice for your family.
What Is a 529 College Savings Plan?
A 529 plan is a type of investment account that can be used to pay for future college costs. Sponsored by states, state agencies and educational institutions, 529 plans can be opened on behalf of a beneficiary. The money you contribute to the plan is invested — with the potential to grow (although there's also a chance that the plan could lose money) — until it's time for your child to go to college. Not only do these plans have the potential to grow tax-deferred, but you also may not have to pay federal or state taxes when you use distributions from the plan to pay for qualifying educational expenses at an accredited institution (see below).
Anyone can open a 529 savings plan on behalf of a child, including aunts, uncles, grandparents, cousins and even non-relatives. Plans can be transferred to a qualified member of the beneficiary's family, according to the Internal Revenue Service (IRS). There are also no limits as to how many 529 plans a person can set up, and maximum contributions vary by plan. Generally, the IRS does not impose a maximum contribution limit, but it does apply gifting taxes where applicable. For more information on a specific plan's maximum contribution, consider consulting your plan's program description.
There may be special tax advantages to a 529 college savings plan. While contributions may or may not be tax-deductible, your money does grow tax-deferred. Also, as long as the contributions are being used for qualified expenses, you generally won't have to pay federal and state taxes. If you take a distribution from a 529 plan that does not meet the criteria for qualified educational expenses, you may be required to pay a 10 percent tax penalty on top of the income tax you will pay on any gains. Of course, your home state of residency may have different rules and tax benefits (the College Savings Plans Network offers a helpful comparison tool).
Due to the 2017 federal tax overhaul, you may also be able to withdraw up to $10,000 a year per beneficiary for qualified K-12 expenses.
Prepaid Tuition vs. College Savings
There are two types of 529 plans: prepaid tuition plans and college saving plans. With prepaid tuition plans, the account holder can purchase credits at participating colleges and universities, which can then be used to pay for future tuition and school-related fees. One significant benefit of a prepaid plan is that it allows the account holder to secure tuition at current rates. Let's say you purchase shares that are now worth two-thirds of tuition at a public school in your state. In this case, the shares will still be worth two-thirds of the tuition in 10 or so years when it's time for your child to head to college.
Prepaid tuition plans bring some caveats, however: The credits usually can't go toward room and board, and participating higher education institutions are generally public or in-state schools, not private ones. As most prepaid tuition plans are sponsored by state governments, most plans require that the future student (i.e., the beneficiary) or account holder be a state resident. Also, if the beneficiary decides not to attend a participating school, they may get less money than what was put into the account.
College savings plans can be put toward qualified expenses, and withdrawals from the plans can usually be put toward any accredited college or university. However, there may be tax consequences depending on the school that you choose. Keep in mind, however, that 529 college savings plans are investments that will fluctuate with changes in market conditions and therefore may lose value.
How Can the Money Be Spent?
Money saved in a 529 college savings plan can only go toward expenses related to post-secondary education at an accredited college, university or vocational school. You may also be able to withdraw up to $10,000 a year per beneficiary for qualified K-12 expenses. Qualified expenses may include tuition, fees, room and board (with limitations), required books and supplies, computers and related equipment. On the other hand, money invested a prepaid tuition plan can only be put toward tuition and school-related fees.
It's important to note that you can't use funds from either plan type toward expenses such as food, cellphone payments, clothing, entertainment, transportation or travel. You also can't use money from a 529 college savings plan for student loan repayments.
When trying to decide whether a 529 college savings plan is a right fit for your family, consider looking at your current financial situation, as well as your time frame for saving for your child's college expenses. Understanding what a 529 plan is and how it works could help you decide whether it's a smart move for your child's future.