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What to Consider Before You Set Up a 529 Plan

Investments
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mother who's considering setting up a 529 plan spending time with her happy teenage daughter

If you're just preparing to start saving for your kids' college education, chances are you may wonder about setting up a 529 plan. Such a plan is one of many ways to put money aside for higher education, and there are a lot of considerations that can influence how you balance it with your other savings strategies.

These plans are named after Section 529 of the Internal Revenue Code, as they're a type of college savings account with a special tax structure. You fund the account with after-tax contributions, which means you can't take a federal tax deduction on those contributions. However, the investment grows tax-free, and you don't pay taxes on funds withdrawn from the account as long as they're used for what the government considers qualified expenses, which include college tuition, books, fees, supplies, equipment and sometimes room and board. (If money from a 529 plan is used for non-qualifying expenses, it can be subject to a 10 percent penalty, plus income taxes on the investment gain.)

Advantages of a 529 Plan

Here are a few reasons why some people like investing in a 529 plan:

  • Federal tax savings: As noted above, the post-tax investment grows tax-free, and there are no taxes due when used for qualified educational expenses, including tuition, books, fees, supplies, equipment and sometimes room and board. Again, penalties and taxes apply to any unqualified withdrawals.
  • State tax savings: While there's no federal tax deduction for investing in the plan, some states offer residents a state income tax deduction, which gives you an additional tax benefit and financial incentive to invest in the state's plan.
  • Account transfers: The account owner is the adult who opened the account, and the owner names the beneficiary. The owner can change the beneficiary, so if one child doesn't need all the money for college, the account can be used for another family member.
  • The donor controls the account: Although the funds are intended for a third party's college expenses, you as the owner make the actual withdrawals and direct the money toward the right expenses.
  • Others can contribute: If your child's grandparents want to help you save for college, for example, they can contribute to the same account or start their own. Non-relatives can contribute to a 529 plan as well.

Choosing a Plan Type

Learning about a 529 plan is important because there are a lot of factors to consider. To start, there are two kinds of 529 plans, including a prepaid tuition plan and an education savings plan. A prepaid tuition plan lets the account holder purchase credits or units at a specific participating college. You pay a percentage of tuition or the value of the credits at today's prices, so when it's time for college, you can apply the plan funds without worries about inflation. This plan only covers tuition costs, and of course your child may not end up attending that particular school, in which case you may be able to use some or all of the funds at another college or university.

The more common plan type is the education savings plan. This approach is more flexible, as you're saving money that can be used at any university or college, and the money can be applied to all qualified educational expenses. The penalty and taxes for unqualified expenses apply to education savings plans, however.

Each state offers a 529 plan (you can view a full breakdown from College Savings Plans Network), and you may receive tax advantages if you're a resident of that state — the plan may allow in-state residents to deduct some or all of their contributions from their state income tax. You can sometimes invest in another state's plan, though you would not get the tax benefits from that state.

Other Options to Consider

Different plans have different fees, which might include an application or enrollment fee, ongoing administrative fee, asset management fee or brokerage fee. These fees may be collected by the plan itself, the state sponsor of the plan, or both.

A 529 plan is also an investment, meaning it comes with risk. A plan's investment options usually include stock or bond funds, which are not guaranteed to increase in value and, depending on market fluctuations, can actually lose value. That's why it's important to pick an investment fund with a risk level you can tolerate. Some funds are more aggressive than others, and your risk tolerance can change as your child gets closer to withdrawing the money. Some plans include age-based accounts, which adjust the risk depending on the date the funds will be needed.

Where to Buy a 529 Plan

You can invest in a 529 plan through a registered representative or from an investment company directly. Registered representatives can provide you with informed recommendations to help choose the best plan for you, especially as a part of your family's larger financial plan. Those who are comfortable doing the research on their own can certainly invest directly through a plan as well.

Before setting up a 529 plan, it can help to do your research. This may mean calling your registered representative, or spending time looking at your state's plan to see if it offers benefits you can't get elsewhere. You can even set up some 529 plans without funding them right away, adding money on a regular basis or in lump sums. The goal is for the investment to grow over a long period, giving you plenty of time to save for college without paying taxes on the earnings — until your child (or children) is ready to put the money to good use!

IMPORTANT DISCLOSURES
Information provided is general and educational in nature, and all products or services discussed may not be provided by Western & Southern Financial Group or its member companies (“the Company”). The information is not intended to be, and should not be construed as, legal or tax advice. The Company does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. The Company makes no warranties with regard to the information or results obtained by its use. The Company disclaims any liability arising out of your use of, or reliance on, the information. Consult an attorney or tax advisor regarding your specific legal or tax situation. 

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