Want to Save Money for College? Think About a 529 Plan.

Photo courtesy of bengt-re

Okay, so you want to save something for your child’s college education. Where should you put the money?

Well, according to research by Sallie Mae, here’s how parents in 2014 are making that decision:

• 45% are using a savings account
• 29% are using a 529 plan
• 27% are using a checking account
• 20% are using a general investment account
• 18% are using a retirement account
• Various other percentages for various other types of accounts

What immediately jumps out to me is the small percentage of people who are using an account specifically designed to save for college. Only 29% of people who are saving for college are using a 529 plan. And 18% are using their retirement accounts! Eek!

If you really want to save money for college, it makes sense to put at least some of it into an account that gives you special incentives to do so.

And in my opinion, there’s usually no better way to do that than with a 529 plan. Here’s why.

What is a 529 plan?

Before we get into the benefits, let’s just quickly talk about what a 529 plan is.

A 529 plan is just a type of account that’s governed by certain rules. These rules give it advantages when the money is used for college, but also place some restrictions on it when it’s not (we’ll get into some specifics below).

This is a lot like a 401(k) or IRA, where you get special tax benefits but there are also restrictions on when you can take out the money. It’s just that the rules for a 529 revolve around education spending instead of retirement.

It’s also worth knowing that 529 plans are run by states. That is, each state has one or more 529 plans that it runs, and when you open an account you have to choose which state plan you want to participate in (again, I’ll get into some specifics below).

Got it? Okay cool. Let’s get into some reasons why a 529 plan can be a great way to save money for college.

Tax benefits

This is the MAIN reason to choose a 529 plan over other options like a savings or investment account. Those options may give you a little more flexibility, but they won’t give you the tax benefits.

A 529 plan has tax benefits that are a lot like a Roth IRA, just for college instead of retirement, but with a little extra twist in certain states.

For federal income tax purposes, your contributions are made after-tax, meaning you get no current deduction for making a contribution. This is just like a Roth IRA.

But in some states, your contributions CAN be deducted for state income tax purposes if you’re a resident of that state AND you contribute to that state’s plan. Here’s a good list of states where you can take the deduction, including the maximum amount that each state allows you to deduct in a single year.

And in addition to all of that, you get two extra tax benefits for BOTH federal and state purposes:

1. Your money grows tax-free within the account. This is in contrast to regular saving and investment accounts where your earnings are taxed as you go along.
2. You can withdraw the money tax-free (again, like a Roth IRA) IF the money is spent on “qualified higher education expenses”. Here’s a quick description of what that means, but basically if you use it to pay for college expenses then you can take it out tax-free.

Even if you can’t get the state income tax deduction, those last two tax benefits give 529 plans a big leg up over a lot of other savings options.

Flexibility with college choices

There are two basic types of 529 plans, each with different amounts of flexibility in terms of which schools you can use them for:

1. Pre-paid tuition plans, and
2. Savings plans

Pre-paid tuition plans come in a few different flavors, but essentially they let you pay a certain amount of money today in order to lock in a certain amount of education later. This can be good, but one problem is that you’re often limited to only a certain set of schools. If your child would like to go somewhere else, the 529 plan won’t be of any use to them.

A savings plan is different in that it doesn’t guarantee anything. You put your money in, invest it according to the plan’s options, and whatever money is there when it’s time for college can be used for whatever expenses you actually have.

One of the big benefits of a savings plan is that you aren’t limited in terms of which schools you can use it for. No matter where your child wants to go to school – in state or out, private or public – the money in your 529 savings plan can be used to help cover the cost.

And actually, it’s not even just limited to traditional college programs. The money can be used for any qualified “higher education” institution, which can include graduate programs and other types of post-high school education. Here’s a tool that can help you determine whether a particular institution might qualify, though it’s always best to verify with a specialist.

As an example, back in 2010 I enrolled in an online self-study program through Boston University to complete the education requirements for the CFP® exam. Even though it wasn’t a traditional undergraduate or graduate program, I was able to use 529 funds to cover the costs.

So with a savings plan, you have a lot of flexibility in terms of how the money gets used. That doesn’t mean that it’s the right way to go 100% of the time, but that flexibility can be a big advantage.

Some flexibility when the money isn’t needed for college

Typically, any earnings you withdraw from a 529 that aren’t used for qualified education expenses are subject to both taxes and a 10% penalty (the amount you’ve contributed is never subject to either). This is one reason people might be hesitant to use it.

This is a risk and should definitely be considered before putting huge amounts of money into a 529 plan. But there IS some flexibility for circumstances where your child doesn’t end up needing the money for school.

First, if your child receives a scholarship then you can typically withdraw up to the amount of the scholarship from your 529 without incurring any penalty. You’ll still have to pay taxes on the earnings, but avoiding that 10% penalty is nice. I would definitely recommend talking to a tax professional before doing this though.

Second, in most cases it’s very easy to change the beneficiary of a 529 plan without any taxes or penalties. So while you might originally set it up for one child, if that child doesn’t end up needing the money you can always change the beneficiary to their sibling, or even change it to yourself or a grandchild. Here’s a quick overview of what you’re allowed to do. So you’re almost never locking yourself into a situation where just one person can use the money.

Very few restrictions on contributions

Unlike with other college savings options (like a Coverdell ESA), and even certain retirement savings options, there are NO income limits when it comes to 529 plan contributions. That means that anybody can contribute and get the tax benefits, no matter how much money they make.

As of 2014, the maximum contribution without tax consequences is $14,000 per person, per beneficiary. So a married couple could actually contribute up to $28,000 per year, per child (because each parent gets a $14,000 contribution allowance).

And if you want to get really crazy, the IRS will actually allow you to contribute up to 5x that much in a single year, with NO tax consequences. That’s up to $140,000 in a single year for a married couple! Per child! (Note that if you do this, any further contributions within the next 5 years may be subject to special taxes. This is another area where you should definitely talk to a professional first.)

Now, none of this is probably incredibly relevant for most of us (myself DEFINITELY included). But still, it’s nice to know that this is a tool you can use no matter what your level of income. You’ll never be phased out.

You can pick a plan from any state

Finally, it’s important to know that you’re not limited to the 529 plans offered by your state. You’re only eligible for a state income tax deduction if you contribute to your state’s plan (and your state allows a deduction), but otherwise you’re free to choose any plan you want.

As an example, we lived in Massachusetts when our first son was born, and Massachusetts doesn’t offer a state income tax deduction. Without that hook, there was no particular reason to favor the Massachusetts plan, so we looked around and eventually decided to use Nevada’s plan offered through Vanguard because we liked the investment offerings and the low fees. (Though we might choose the Utah plan if we did it over again).

When we moved to Florida (just a few weeks ago), it was time to revisit that decision. But since Florida doesn’t even have a state income tax (SWEET!), there was once again no real incentive to switch. So Nevada it continues to be!

So while not getting a deduction is kind of a bummer, the silver lining is that it frees you up to shop around.

Conclusions

There’s no one right way to save for college. And in fact it can make a lot of sense in some situations to use a few different types of accounts just to give yourself a little bit more flexibility.

But for any money that’s really specifically meant to be for college, it’s hard to beat the advantages of a 529 plan.

What types of accounts are you using to save for college? I’d love to hear the thinking behind your strategy.