With student debt a major topic of economic and budgeting concern, you may be looking for ways to help minimize your child’s tuition debt or even avoid taking out loans altogether. But how can you do this while still ensuring your child receives the education you want for them?
The easiest solution is to save money for college. As we wrote in our Beginner’s Guide to College Financial Planning, a college savings plan – also known as a 529 plan – helps you pay as much money as possible up front, versus taking out loans that you repay later.
This article provides insights into how to save for college and what pitfalls to watch out for.
What Is a 529 Plan?
A 529 Plan is a college savings plan, where you can save money for college tax-free. You don’t pay taxes when you contribute, and you don’t pay taxes when you take the money out, as long as it’s actually used for education expenses. Generally, people will start a 529 plan for their child or grandchild, who is referred to as the “beneficiary” of the account.
These plans are called 529 plans because that is the section of the Internal Revenue Code that these plans are laid out in, but formally and legally, they are known as Qualified Tuition Programs.
The biggest benefits to a 529 plan versus keeping all your money in cash or savings is that these accounts help your money go further than they would otherwise. Depending on the type of account you use (see below), you can either compound your money as an investment or pay a lower tuition by locking in the price of college early.
How do I get a College Savings Plan?
Unlike other investments, these plans are typically administered by the states. While the details of each plan differs from state to state, there are two basic types of 529 plans:
College Savings Plans are offered by every state and Washington, D.C.
College savings plans are similar to other investments: you get high returns and compounded money based on market performance. The investments are typically in mutual funds, and they tend to be age-based, where they become more conservative as the beneficiary gets closer to college age, although some are risk-based.
These plans can be used on all education expenses, which typically means tuition, fees, and room and board, and they can be used at any college or university – and in some states, even elementary or high schools.
Prepaid Tuition Plans are more rare and are only offered by a handful of states and higher education institutions. A prepaid plan is just what it sounds like—you can pre-purchase tuition at a specific rate, and when your child is ready to go to college, the account is paid out at the rate determined back when the account was started.
These plans typically have more limitations:
- They cannot be used to pay for room and board
- They can’t be used for tuition at elementary and secondary schools
- They typically have residency requirements
- They are limited to specific schools—especially when the plan is through a higher education institution rather than the state.
Pros and Cons of 529 Plans
For every investment, it pays to weigh the pros and cons of what the plan entails, and these plans are no exception.
Pros of 529 Plans
- If you get the plan through the state you live in, you typically get really good benefits.
- In addition, 529 plans don’t require mandatory withdrawals by the beneficiary’s 30th birthday to avoid a tax penalty. In fact, a leftover 529 plan can be rolled over to a new beneficiary, a process that may be continued indefinitely until the savings are exhausted.
Cons of 529 Plans
- You may feel limited by the lack of variety in investment options or lack of control over the assets.
- These plans are specifically used for education, and some (especially prepaid plans) can only be used for specific schools.
- Withdrawals that are used for non-education expenses or for anything not covered by the plan are subject to a 10% fee in addition to federal and state taxes, so you’ll need to be careful not to overestimate the amount needed in the account.
- As with any other investment, you’ll need to pay attention to fees and commissions; remember, every dollar that goes into a fee doesn’t go towards college.
- If you’re not investing for a long time, you may not see the returns you’re hoping for. The longer you can invest, the more your money will compound.
- Some plans are not guaranteed by their states, so if they have a shortfall, you may lose your money.
- Having money in a 529 plan will affect qualifications for need-based financial aid.
Starting a College Savings Plan
To get started with a 529 plan, you can check out a list of college savings plans by state to see what your state offers. However, before going too deep into the process, it’s a good idea to meet with a financial advisor to discuss all the variables for your child and the plans you’re considering.
We make it easy to find an advisor near you to get started on planning for a bright, debt-free future for your child or grandchild.