There are smart ways to save for college that come with tax benefits.
The average cost of tuition for the 2020 — 2021 school year for a private institution is $37,650, according to College Data. For public institutions for in-state residents, it was $10,560, while the price tag for out-of-state residents was $27,020.
A 529 plan is an investment account that can help save for college, but there are some notable downsides. It can help you plan for future educational expenses, but there are taxes and penalties associated should you not use it for educational purposes.
Read on to learn more about a 529 and whether you should invest in one.
What Is a 529 Plan?
For the most part, a 529 plan is sponsored by states, state agencies, or educational institutions. When you open a 529 plan for a beneficiary, there are usually a handful of investment options to choose from such as mutual funds and ETFs.
You can open and invest in a 529 plan for any state, not just the state you live in. So you’ll want to do some comparison shopping and see which 529 plan is the best or your needs, situation, and benefits that appeal to you the most.
“Most of these 529 plans offer something called a target date fund that makes it easy on the customer,” says Jovan Johnson, a CPA and founder of Piece of Wealth Planning, a virtual planning firm. “It’s an investment option that adjusts based on the risk of the timeline. So it starts off heavier in stocks. And as they get closer to attending college, it dials down that risk over time.”
A target date fund helps take the guesswork out of retirement planning by adjusting your level of risk comparatively to your age. The younger you are the riskier your investments, and the older you are, the less risky they get. In relation to a 529, the target date fund will be more conservative as your child approaches college age.
An attractive feature of 529 plans is that they come with some tax advantages. 529s grow tax deferred, meaning the investments grow tax-free until the investor pulls them out, but only if they’re used for qualified expenses like college tuition, room and board. “It comes out with no taxes, and no penalty,” says Johnson.
Most states have at least one 529 plan, and you don’t need to open a plan in your own state. However, if you’re a resident of your state’s 529 plan, you might be able to take advantage of tax advantages at the state level. If you sign up for a 529 plan administered in another state, then you won’t be able to enjoy any state tax advantages.
529 plans have a custodian, which is the person who opened the account, and a beneficiary. A beneficiary can be a child or another relative, friend, and even yourself. There are no limits on how many 529 accounts you can open. Someone can also be the beneficiary of more than one account.
529 prepaid plans
Unlike a 529 college savings plan, which has a lot of flexibility, a 529 prepaid plan is usually linked to a particular in-state, public college, university, or institution. As the name implies, how it works is that you are prepaying for a number of credits for this particular institution.
“The prepaid plan is not as popular because it’s not as flexible,” says Johnson. “Most of the time, when you sign up for the prepaid plan, you have to be a resident of that state, and you can only use it for an in-state public institution.”
Typically 529 prepaid plans do not allow you to use that money toward room and board.
How to Open a 529
Opening a 529 is a two-step process.
“It’s almost the same as opening up an online brokerage account,” says Jackie Cummings Koski, a certified educator in personal finance. “You can go to the website of the state 529 plan, and it’s going to ask you for your name, your address, your phone number, and you would name the beneficiary, which typically is going to be whoever the person is you’re opening up for.”
After you’ve set up the account, you choose your investments. “It’s not any harder than your 401(k) at work,” says Koski. “Once the account is set up, you get a menu of investments very similar to what you would get in your 401(k).”
Some state plans give you the choice to work with a fund manager, says Koski. This comes with an added cost. A nice little bonus is that some states will run a promotion, where they’ll give you $50 or $100 to open a 529 plan, explains Koski. It’s usually on May 29th each year, which is deemed 529 Day.
Downsides and Alternatives to a 529 Plan
In some states, there are minimum contribution requirements to open a 529 plan. For example, in Arkansas, an initial contribution of $500 is required. And in most states, there is a monthly requirement, sometimes in the amount of $10 or $50.
If you make a withdrawal to cover expenses that are not education related, the IRS will count that as income and you’ll have to pay federal taxes on it. Plus there is a 10% fee.
If you decide against a 529 plan, there are other ways to pay for college. These include savings accounts, Roth IRAs, and brokerage accounts to name a few. If you opt for a savings account, a high yield savings account could be a good option. This gives you flexibility to use the funds for other things should your child decide not to go to college.
A Roth IRA is another option. Roth IRAs are retirement accounts that let you invest after tax-dollars. Although you can’t pull your gains out without penalty until you’re 59 ½ but a Roth IRA allows college education as a qualifying reason to withdraw investments without penalty. A brokerage account lets you deposit and withdraw money but remember you must pay capital gains on the growth.
What Happens When You Don’t Use It?
If you don’t end up using the money in a 529 account or don’t end up using it for qualified educational expenses, it could potentially turn into a big headache, explains Johnson. That’s because now you’re talking about potential taxes and penalties. Should you not use all the funds in a 529 plan, you would be hit with a 10% withdrawal penalty, plus owe any income taxes on it.
The good news is that there are quite a few ways to work around it, adds Koski. For one, you can roll over the money into an account for a different beneficiary. You can roll over funds as long as it’s a qualified family member. The IRS lets you do this once every 12 months without getting hit with the 10% penalty. However, you will need to pay income taxes.
Due to the SECURE Act in 2019, funds from a 529 account can be used to pay up to $10,000 of a beneficiary’s student loan debt, or the student loan debt of their sibling.
And if your child receives a scholarship, you are able to withdraw funds from your account in the amount of the scholarship without incurring a penalty or fee.
Before you decide to withdraw funds, it’s important to go through the full list of qualified expenses to make sure you don’t miss anything, says Koski. For instance, your child’s internet while they’re at school and computer can be for qualified expenses.
Can You Use It for More Than One Child?
Yes. There are no limits as to how many 529 plans you can open. Plus, the beneficiary doesn’t have to be just your child, says Koski Cummings. “You can open up a 529 for your niece, your nephew, your grandchild, your brother, your younger sibling and so on,” she says. As mentioned before, you can even use it for yourself.
“My general opinion is that 529 plans are great vehicles,” says Koski. “You’ll have people that are doing great with the 401(k) or IRA, and they’re looking for the next type of account where they could actually get some type of tax benefit from it.
“Traditionally people think of a 529 being for their kids, but it’s not just for kids,” continues Koski. “It could also be an adult going back to school.”
Here are 529s in every state:
|State||Plan Name||Tax-benefit for in-state contributors?||Minimum contribution|
|Alaska||Alaska 529||No||$25 minimum initial contribution|
|Arizona||AZ529||Yes||$25, maybe less|
|Arkansas||Arkansas 529 GIFT Plan||Yes||$25 one-time contribution, OR $10/month (or $30/quarter) recurring contributions,|
OR $5 per pay period if contributing through payroll direct deposit
|California||ScholarShare529||Only for higher education (funds used for K-12 expenses are taxed)||None|
|Colorado||CollegeInvest||Yes||Varies by plan|
|Connecticut||CHET (Connecticut Higher Education Trust)||Yes||None|
|Delaware||DE529 Education Savings Plan||Yes||$50 or $15/month|
|District of Columbia||DC College Savings Plan||Yes||$25|
|Florida||Florida 529 Savings Plan||No||None|
|Georgia||Path2College 529 Plan||Yes||$25 or $15 a month through payroll deduction|
|Idaho||IDeal – Idaho College Savings Program||Yes||$25; $25/month or $75/quarter; $15/paycheck|
|Illinois||Bright Start or Bright Directions||Yes||None|
|Iowa||College Savings Iowa 529 Plan||Yes||$25|
|Kansas||LearningQuest 529 Education Savings Program||Yes||None|
|Louisiana||START Saving Program||Yes||$10|
|Michigan||MESP (Michigan Education Savings Program)||Yes||$25 or $15 per pay period|
|Mississippi||College Savings Mississippi||Yes||$25|
|Missouri||MOST – Missouri’s 529 Education Plan||Yes||$1|
|Montana||Achieve Montana||Yes||$25 or $15 payroll deduction per payroll period Ugift: $15; UPromise: $25|
|Nebraska||NEST 529 Advisor Plan||Yes||None|
|Nevada||Nevada College Savings Plans Program||No||$15 (for the SSgA Upromise 529 plan)|
|New Hampshire||UNIQUE College Investing Plan||Yes||None|
|New Mexico||The Education Plan||Yes||None|
|New York||New York’s 529 College Savings Program||Yes||None|
|North Carolina||College Foundation of North Carolina||Yes||$25|
|Ohio||Ohio’s 529 College Advantage||Yes||$25|
|Oklahoma||Oklahoma 529 College Savings Plan||Yes||$25|
|Oregon||Oregon College Savings Plan||Yes||$25|
|Rhode Island||CollegeBound Saver||Yes||None|
|South Dakota||CollegeAccess529||Yes||$250 for in-state residents; $1,000 for out-of-state|
|Texas||Texas College Savings Plan||No||$25|
|Washington||DreamAhead College Investment Plan||No||$25|