Saving for children’s college can be intimidating. College costs are expensive, and freshman year seems distant. And with so many savings options, where does one begin? The 529 plan is the best option to address all three concerns.
Two types of plans
529 plans are available in two types: education savings plans and prepaid tuition plans. Education savings plans are the more common and preferred type of plan. It allows parents, grandparents, and others to invest money for qualified education expenses. Prepaid tuition plans are less common. Offered by some states and colleges, they often come with residency requirements and allow parents to prepay tuition at certain schools for a set price today. Skip the prepaid plans; return on investment is typically immaterial, your prepaid funds often are not guaranteed, and your child may choose to attend school elsewhere.
What are the benefits?
Contributions to 529 plans are not tax-deductible at the federal level, but many states offer deductions or credits. Your money grows tax-free, and withdrawals to pay for qualified educational expenses are free from federal and, in most cases, state taxes. The list of qualified expenses is generous, including room and board, tuition, books, and computer equipment. It is easy to make beneficiary changes. Unused funds can be directed from one family member to another to pay for their education expenses.
There are as many investment options as there are plans, but certain features are more common than others. Most account owners choose a portfolio allocation that automatically becomes more conservative as the beneficiary approaches college age. Other options include 100% equity or fixed income funds and balanced options in between. Some states offer FDIC-insured bank options to protect your principal, but such instruments will also limit investment gains.
A 529 plan is the most generous college savings account available. Each state sets its aggregate contribution limits per beneficiary, ranging from $235,000 to $542,000, a larger capacity than most will ever need. After that, no additional contributions are allowed, but earnings can continue to accumulate. There are no annual contribution limits, though account contributions are considered gifts for federal tax purposes. Give more than $15,000 a year to a single beneficiary, and you will owe gifts tax.
Which state plan is best?
Each state offers at least one plan, and you are not limited to the plan(s) from your state. You could live in Kansas, set up a 529 account with Colorado, and pay for educational expenses to a school in Iowa. While your state of residence may only offer tax breaks on contributions to the state’s 529 plan (some offer tax breaks regardless of where you make contributions), differences in plan construction and costs may leave that a worthwhile trade-off.
Look to your state plans first to take advantage of available tax breaks on contributions. You will need to weigh the trade-offs of favoring an out-of-state plan vs. something closer to home. Avoid advisor-sold plans. They are more expensive than direct-sold plans.
Avoid plans with zero costs because those plans often limit investment options to cash vehicles like insured bank products or savings accounts. Products like these are lower risk and lower return and diminish or eliminate the possibility of tax-free growth. Focus on plans with a reasonable cost structure that offer a combination of low-cost options available individually or bundled in age-based or year-to-enrollment pools.