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529 plans are education investment accounts with special rules and tax benefits that help families save for college—and even for K-12 tuition. These plans come in multiple forms: a prepaid tuition plan or a savings plan that allows after-tax contributions toward investments in mutual funds and exchange traded funds.
A 529 plan can be a smart way for you to start saving early for your child’s college education.
Plans are available in all 50 states, with plan managers assigned to pick investments that it feels are the best for that state’s plan, potentially resulting in an easier investment process and lower fees negotiated because of group buy-ins.
Still, while every state offers a plan, they are not all the same. The best 529 plans charge the lowest fees and offer a better selection of investment options.
Read on to learn more about saving for college, along with 529 plan pros and cons.
What Is a 529 Plan?
A 529 plan—named after the section in the Internal Revenue Code that authorizes so-called qualified tuition plans—is an education investment account with rules and guidelines set by individual states. Each state negotiates its fees for management and mutual funds separately, similar to how 401(k) plans fees are negotiated for companies.
These education savings accounts originally were designed just for college savings. Now, they also can be used for some K-12 costs in certain states. You can now make up to $10,000 in tax-free withdrawals annually to pay for expenses at public, private or religious elementary and secondary schools.
529 Plan Benefits: 8 Ways to Help Save for College
Because they are so widely available, you should be able to compare many college savings plans. This will allow you to find the one that offers the options best suited to your needs. 529 plans offer several benefits, including:
- Federal tax breaks. You won’t pay taxes on 529 plan earnings, provided you use the money for qualified higher education expenses, vocational school, K-12 tuition or apprenticeship fees or expenses. Qualified higher education expenses include tuition and fees, room and board (as long as you are enrolled at least half-time), books and computers or computer equipment for the student’s use.
- State tax breaks. States may offer tax benefits such as tax credits or a tax deduction for contributions to 529 plans. Tax deductions often have limits per beneficiary and per taxpayer. For instance, Utah married couples filing jointly can contribute up to $4,080 per year per beneficiary to that state’s plan, my529, and receive a 5% state income tax credit. So, contributing $4,080 means $204 in tax savings.
- Age-based options. You don’t have to be an investing expert to develop a successful 529 plan savings strategy. You can choose a package of investments based on the age of the student and how risk averse your family is. Families that fear losing money on their investment likely will choose a conservative plan that offers less exposure to the stock market.
- No Income-based restrictions. Certain education tax benefits—like popular education tax credits—set a maximum income limit to qualify, meaning not all families can take advantage. 529 plans don’t set such restrictions. You can qualify for federal tax breaks on 529 earnings no matter what your income is.
- Prepaid tuition. About a dozen states offer guaranteed tuition plans that allow you to save for future tuition at today’s prices. This allows you to sidestep tuition price hikes and inflation. You can compare plans by state to see if your home state offers a prepaid tuition plan.
- Flexibility of use. 529 plan funds can be used at qualifying apprenticeship programs, trade schools and some continuing education institutions. Parents even can use leftover 529 plan funds to take courses to further their own careers or to repay up to $10,000 in student loan debt.
- A range of choices. You can choose a plan from any state, but make sure to do your homework as some plans are better than others. You just have to double check your state’s department of taxation website as to whether plans from other states still qualify for the income tax deduction.
- The ability to change investments. Federal tax law allows the account holder to change investments twice a year or when there’s a change in beneficiary. That means if you don’t like your plan’s performance, you aren’t stuck with your initial selection. “Check your investments in your 529 plan account quarterly to ensure you are invested in the right mix of options,” says Mary Anne Busse, a 529 plan expert and managing director at Great Disclosure, a consulting firm in Royal Oak, Michigan.
“Many people find themselves in individual investment options that may be too aggressive if their student is about to head off to college,” Busse says. If you’re unsure how to invest, look on 529 plan sites for tips concerning what kind of investor you are, she says. You also can call the plan’s customer service line for help choosing the best investment package for you.
529 Plan Drawbacks
As with any investment, there are risks to using a 529 plan to save for college. There are pitfalls you should look out for when investing in a college savings plan, including:
- Tax penalties for certain withdrawals. Do your best to make sure you can afford your contributions as part of your household budget, so you won’t have to withdraw the cash you put in. While your withdrawals for qualified education expenses are tax-free, non-qualified withdrawals are subject to federal and state income taxes, as well as a 10% federal income tax penalty on earnings.
- Limits on investment flexibility. While you have a range of choices when it comes to 529 plan investments, you’ll have to choose within that plan’s offerings. Investors who want to be more involved may want to choose plans or other investment account types with more options.
- Running out of money before college. Money that’s used for K-12 expenses doesn’t have much time to grow from earnings. Thus, more of the money comes from the account owner’s and contributors’ pockets. It also limits the amount available when it’s time for students to go to college.
529 plans allow you to earmark savings for a wide range of academic needs, while also taking advantage of state and federal tax benefits for plan holders and contributors. College savings plans are fairly easy to set up. You should always review 529 plan state tax benefit rules to make sure you choose a plan that qualifies. When it comes time for withdrawals, verify what’s considered a qualified education expense.