Ideally, you want a savings vehicle that:
- Doesn’t impose arbitrary income limits on eligibility;
- Lets you contribute a little or a lot, depending on what else happens to be going on financially in your life at the moment;
- Lets you set up automatic, recurring contributions from your checking account so you can put your savings effort on autopilot; and
- Offers the potential to stay ahead of college inflation, which has been averaging 3% to 4% per year.1
- Oh, and some tax benefits would be really nice, too, so all your available dollars can go to college and not Uncle Sam.
Can you find all of these things in one college savings option? Yes, you can: in a 529 plan.
529 college savings plans offer a unique combination of features that are hard to beat when it comes to saving for college, so it’s no surprise why assets in these plans have grown steadily since their creation over 20 years ago.
People of all income levels can contribute to a 529 plan — there are no restrictions based on income (unlike Coverdell accounts, U.S. savings bonds, and Roth IRAs).
Ease of opening and managing account.
It’s relatively easy to open a 529 account, set up automatic monthly contributions, and manage your account online.
For example, you can increase or decrease the amount and frequency of your contributions (e.g., monthly, quarterly), change the beneficiary, change your investment options, and track your investment returns and overall progress online with the click of a mouse.
529 plans have high lifetime contribution limits, generally $350,000 and up. (529 plans are offered by individual states, and the exact limit depends on the state.)
Also, 529 plans offer a unique gifting feature that allows lump-sum gifts up to five times the annual gift tax exclusion — in 2020, this amount is up to $75,000 for individual gifts and up to $150,000 for joint gifts — with the potential to avoid gift tax if certain requirements are met.
This can be a very useful estate planning tool for grandparents who want to help pay for their grandchildren’s college education in a tax-efficient manner.
The main benefit of 529 plans is the tax treatment of contributions. First, as you save money in a 529 college savings plan (hopefully every month!), any earnings are tax deferred, which means you don’t pay taxes on the earnings each year as you would with a regular investment account.
Then, at college time, any funds used to pay the beneficiary’s qualified education expenses — including tuition, fees, room, board, books, and a computer — are completely tax-free at the federal level.
This means every dollar is available for college. States generally follow this tax treatment, and many states also offer an income tax deduction for 529 plan contributions.
But 529 plans have some potential drawbacks.
Tax implications for funds not used for qualified expenses.
If you use 529 plans funds for any reason other than the beneficiary’s qualified education expenses, earnings are subject to income tax (at your rate) and a 10% federal penalty tax.
Restricted ability to change investment options on existing contributions.
When you open a 529 college savings plan account, you’re limited to the investment options offered by the plan. Most plans offer a range of static and age-based portfolios (where the underlying investments automatically become more conservative as the beneficiary gets closer to college) with different levels of risk, fees, and management objectives.
If you’re unhappy with the market performance of the option(s) you’ve chosen, you can generally change the investment options for your future contributions at any time. But under federal law, you can change the options for your existing contributions only twice per year.
This rule may restrict your ability to respond to changing market conditions, so you’ll need to consider any investment changes carefully.
529 college savings plans are offered by individual states (but managed by financial institutions selected by the state), and you can join any state’s plan.
To open an account, select a plan and complete an application, where you will name an account owner (typically a parent or grandparent) and beneficiary (there can be only one); choose your investment options; and set up automatic contributions if you choose. You are then ready to go.
It’s common to open an account with your own state’s 529 plan, but there may be reasons to consider another state’s plan; for example, the reputation of the financial institution managing the plan, the plan’s investment options, historical investment performance, fees, customer service, website usability, and so on.
You can research state plans at the College Savings Plans Network.
1 College Board, Trends in College Pricing, 2014-2018
*There are generally fees and expenses associated with 529 savings plan participation. Investments may lose money or not perform well enough to cover college costs as anticipated. Investment earnings accumulate on a tax-deferred basis, and withdrawals are tax-free if used for qualified higher-education expenses. For withdrawals not used for qualified higher-education expenses, earnings may be subject to taxation as ordinary income and possibly a 10% federal income tax penalty. Discuss the tax implications of a 529 savings plan with your legal and/or tax advisors; these can vary significantly from state to state. Most states offer their own 529 plans, which may provide advantages and benefits exclusively for residents and taxpayers, including financial aid, scholarship funds, and protection from creditors.
Before investing in a 529 savings plan, consider the investment objectives, risks, charges, and expenses carefully. Obtain the official disclosure statements and applicable prospectuses — which contain this and other information about the investment options, underlying investments, and investment company — from your financial professional. Read these materials carefully before investing.
Before investing in a mutual fund, carefully consider the investment objectives, risks, charges, and expenses of the fund. This information can be found in the prospectus, which can be obtained from the fund. Read it carefully before investing. Diversification alone cannot guarantee a profit or ensure against the possibility of loss. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any strategy will be successful.
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