One of the many things we parents worry about is offering our children access to opportunity. I want to make sure my child has access to a great education so he can go to college and live a life of his own choosing.
However, looking at the cost of college can sometimes make you believe you’ll never be able to achieve your goal. According to USA Today, the average price for tuition and fees at a private college or university increased to $34,740 for the 2017-2018 school year.
The increase over the past decade has outpaced inflation by more than three percentage points. Tuition at state colleges and universities is rising as well. So what’s a parent to do?
I’m excited to have found a 529 plan—a tax-advantaged savings plan that helps me save for my child’s college education expenses. Also known as qualified tuition plans, 529 plans are sponsored by states, state agencies, or educational institutions.
Your 529 plan is an investment account that gives you tax-free earnings growth and tax-free withdrawals when used to pay for qualified expenses related to education. This can include tuition, fees, books, supplies, equipment, computers, and room and board in some instances.
You should note that the money you invest in your 529 plan is always yours to keep and can be withdrawn for any purpose. However, the earnings portion, or the income after tax, of any non-qualified expenses will be taxed as income and incur a 10 percent tax penalty.
In addition, certain expenses not connected to enrollment in college cannot be used by funds saved in your 529 plan. This can include student health insurance, transportation, and student loan payments.
There are two types of 529 plans: prepaid tuition plans and education savings plans. You can find at least one type of 529 plan in all 50 states and the District of Columbia. There are also prepaid tuition plans sponsored by a group of private colleges and universities.
What’s the difference between the prepaid tuition plan and the education savings plan?
Education savings plans are quite similar to Roth 401(k)s or IRAs in that they allow you to invest your after-tax contributions in mutual funds or other investments. As with any investment, the plan’s value will increase or decrease based on the performance of the options you choose.
With prepaid tuition plans, you have the option to pre-pay all or a portion of the costs of in-state public college education. You may also choose to convert your prepaid tuition plan for use at a private and/or out-of-state college or university.
There is also a private college 529 plan that is solely used to pay for private college costs and is sponsored by more than 250 private colleges. Please note that educational institutions are able to offer prepaid tuition plans, but not college savings plans.
What colleges will allow me to use a 529 plan?
For starters, you are not limited to investing in a 529 in your own state; you can invest in any state you choose. In most cases, you don’t have to worry about whether or not the state that is sponsoring your 529 plan is also the state in which your child will attend school.
For example, it is possible for you to be a Vermont resident, invest in a 529 plan in California, then send your child to school in South Carolina. You are free to use your 529 plan at more than 6,000 colleges and universities in the U.S. and more than 400 foreign colleges and universities.
There are so many choices! How do I choose a 529 plan for my family?
By now, you might be considering investing in a 529 plan. However, I understand how confusing this whole process can be, especially if you’re not familiar with investing. So how do you go from making the decision to enroll to actually making it happen?
1. Choose your plan
Before you decide if you want to go for either the savings or prepaid tuition plan, you need to choose if you want to work with a broker or use a direct-sold option.
If you choose to work with a broker, you are essentially hiring a financial advisor to help you choose the right investments for you. Note that you will be charged a fee to utilize the expertise of the broker. You can expect for your account to increase or decrease in value based on the performance of the investments the broker selected.
If you are comfortable making your own decisions about how to invest your funds, you may go with the direct-sold option. With the direct-sold option, you have the opportunity to choose which investments are best for you through your plan manager. There are no added fees connected to direct-sold 529 plans.
Once you have chosen to either work independently via a plan manager or with the assistance of a broker, you then have to decide if you will go for the prepaid tuition plan or the savings plan.
The major advantage of the prepaid tuition plan is that it allows parents to lock in tuition costs at the current rate. States who operate these plans guarantee that your investment will increase in value as college tuition costs continue to rise over the years.
Most people choose the savings plan, as they work similarly to your 401(k) or IRA, but you should pick whichever plan fits your situation best.
2. Research and compare 529 plans available in your state
There are a few questions you should ask yourself before settling on a 529 plan that works for you:
- What are the fees associated with the plan? Is there an annual fee? Do I have to pay a fee to open the account? Do I have the option of waiving the fee in my home state?
- What expenses can I expect to pay once I make a decision on a plan? An expense is the percentage fee charged on assets by the plan every year. That means that if the fee is 1.00 percent, then you can expect to pay $1 for every $100 invested in the plan. A few states waive a portion of the fee for in-state residents.
- What investment options make the most sense for you? Do you want an investment that will change as your child grows older, or do you prefer a wider investment selection that offers you more control? Would you feel better investing in a product that is FDIC insured, as an example?
- What about customer service? When you call the plan manager, does she pick up the phone right away or do you have to go through a series of prompts? Is anyone available via email? How long does it take for someone to respond to your emails?
Also, over 30 states currently offer a state tax benefit for contributions to a 529 plan. Take the time to review what tax benefits and incentives are available to residents of your state.
Whether or not it is beneficial for you to enroll in a 529 plan in your home state or elsewhere depends upon your savings goals and investment choices—the more years you have invested in your plan, for instance, the less important the state tax benefit becomes. The goal for you is to sign up for a plan that gives you the best investment performance.
3. Open your 529 plan account
Once you’ve decided which plan to invest in and whether you’d like to do it directly with a plan manager or a financial advisor, you will need your own social security number, as well as that of your child. If your child doesn’t have a social security number yet, you can get the process started by naming yourself as the beneficiary for now, then change it later.
The process is quite simple. If you decide the plan is not working for your needs, you always have the option of rolling it over to another plan. The earlier you get started, the greater your potential investment growth.
4. Start making your contributions
You may find that most plans require an initial minimum contribution of at least $25. After that, what you pay and how often you pay it is up to you.
You can set up automatic monthly contributions, as you are probably already doing with your other household bills. You can also opt to make several payments throughout the year around birthdays, holidays, or other events.
What if my child doesn’t use the 529 plan?
If your child happens to decide not to go to college or gets a full ride to the college of her dreams, then what do you do with all that money you diligently saved over the years?
In most circumstances, you will have to pay income tax and a penalty fee on the earnings portion of the nonqualified withdrawal. However, there are some exceptions to this rule. The penalty is waived in the following cases:
- Your child receives a tax-free scholarship.
- Your child attends a U.S. military academy.
- Your child becomes disabled or dies.
Please note that your earnings will be subject to federal and potentially state income taxes.
What do I do with money not used from my 529 plan?
Let’s say you only use a portion of the money you’ve saved for your child’s education. Again, you can get your contribution back, less taxes and fees. Note that you won’t have to pay taxes and fees if you take one of the following actions with the remainder of your savings:
- Change the beneficiary from your child to another qualifying family member.
- Save the money for graduate school.
- Use the money for your own education.
- Withdraw up to $10,000 to pay for K-12 tuition.
- Roll over the funds to a 529 ABLE account, which can assist in the unfortunate event your child suffers a disability.
I hope that I’ve been able to offer you actionable information that will help you move forward in saving for your child’s education. The most important thing for you to remember is that the earlier you get started with saving, the more money you will have available to support your child’s future.