A savings gap exists for most parents between their desire to provide their children with a great college education and their ability to pay for it.
Forty-nine percent of parents want to pay at least 75% of their children's college costs, but only 32% are confident they can cover the costs of their child's preferred school, according to a recent survey by Savingforcollege.com. The survey also found that 15% of parents would consider tapping their retirement savings to pay for their child's college, and 55% would be open to sending their child to a community college for two years to bring costs down.
Parents don't have to take those drastic measures. They can boost their college savings by investing wisely. Parents can put a child's college fund in many places: a savings account, an investment account or an individual retirement account. But there's one account that is specifically designed to help you save for a college education—a 529 college savings plan.
Haven't heard of a 529 college savings plan?
You're not alone. Nearly three out of every four Americans (72%) still don't know what a 529 college savings plan is, according to a survey from financial services firm Edward Jones. And only 24% of millennials have heard about 529 college savings plans.
"The cost of education remains a top concern for many Americans, and yet the downward trend in 529 awareness persists year over year," says Steve Seifert, investment advisory principal at Edward Jones. "We must continue to teach individuals and families about the investments, like 529 college savings plans, that offer attractive and practical ways to save for future college expenses."
So what exactly is a 529 college savings plan?
It is an investment plan, which is sponsored by a state government, where the earnings from the plan are not subject to federal tax and generally not subject to state tax when used for qualified education expenses, such as tuition, fees, books as well as room and board. However, unlike retirement plans, contributions to 529 college savings plans are subject to federal taxes.
Regardless, the federal tax advantages for 529 plans are substantial. Let's say you earn $100,000 annually and contribute $5,000 per year to a 529 college savings account that earns 6% annually for 18 years. With the federal tax advantage, you will have more than $154,500 in the account after 18 years. Without the federal tax advantage, you would have less than $127,800 in the account after 18 years.
You will need those extra savings, especially if your child goes to private school. For the 2015-2016 school year, the average in-state tuition, fees, and room and board for a public, 4-year university was $19,548, according to the College Board, up 3.3% from the previous academic year. At a private, 4-year college, the average tuition, fees, room and board is $43,921, up 3.5% from the previous academic year.
The tax savings gets even better for some 529 plans. In more than half of the states, 529 college savings plans also provide a state tax credit or deduction in exchange for your contributions. For example, contributions to a New York 529 plan of up to $5,000 per year for an individual, and up to $10,000 per year by a married couple filing jointly, are deductible from New York taxable income. That means an individual New Yorker earning $100,000 annually would have a state income tax deduction of more than $330 by making a $5,000 contribution to a New York 529 college savings plan.
What types of 529 college savings plans can I invest in?
There are two types of 529 college savings plans—those sold directly by the states and those sold by financial advisors. Direct-sold 529 plans don't charge sales fees like those sold by financial advisors. However, depending on the state, advisor-sold 529 plans may offer more investment options than direct-sold plans.
You don't have to contribute to your state's 529 plan. But if your state offers a state tax benefit for 529 plan contributions, it usually makes sense to invest in a 529 plan from your state because the tax benefit typically will trump any advantage other state plans can offer. However, in six states—Arizona, Kansas, Maine, Missouri, Montana and Pennsylvania—you can receive a state income tax benefit for contributing to any 529 college savings plan, even those in other states.
How can I figure out which 529 plan that is right for me?
Two websites can help you investigate your options. The College Savings Plans Network, which is run by an association of state treasurers who administer 529 plans, provides plan details and useful comparison tools. Savingforcollege.com offers ratings of both direct- and advisor-sold 529 plans.
Picking the right 529 plan can help you save enough money to pay for your child's college education.