529 plans are a common savings vehicle for college tuition that assists parents with college planning. By offering various tax benefits at both the contribution and withdrawal stages, 529 plans can be an important part of saving for your child’s education.
If you are wondering “when should I start saving for college?”, then educating yourself on 529 plans on your own or by working with a financial planner is a great way to start.
What is a 529 plan?
529 plans are administered at the state level and vary slightly by state, although each state currently has one. It is important to check with your state government to see what kinds of 529 plans are allowed in your state and what college planning tax benefits you may be entitled to. It is important to ensure that you meet your state’s 529 plan residency requirements, as this might significantly affect your ability to claim tax benefits.
The two main types of 529 plans are college savings plans and prepaid tuition plans. While each plan is a strong vehicle for saving for college, they differ in both benefits and structure.
College savings plan
A college savings plan allows you to create a tax-advantaged investment account for saving for your child’s education. Administered through a broker or other entity, it will function similarly to other investment accounts with a number of investment options available.
Contributions to a college savings plan are often tax deductible and in some cases receive certain forms of state grants. Similarly, when you withdraw from a college savings 529 plan for college expenses, the withdrawals will often be free from both federal and state tax.
In contrast, if the withdrawals are made and not used for college expenses then the withdrawals not only will be taxed but also include a 10% penalty from the federal government as well as potential state penalties.
Prepaid tuition plan
In contrast, a prepaid tuition plan is usually a far more state-specific program whereby those saving for college buy prepaid tuition credits at the colleges participating in the program. These colleges are normally public, in-state universities and restricted to state residents.
Compared to a college savings plan, the prepaid tuition plan may be riskier as in some states the credits are not guaranteed by the state if the university experiences financial difficulties.
Furthermore, if the student attends a different college for which the tuition credits were bought, then the credits may be significantly devalued when applied to tuition.
What you need to know before selecting a 529 plan
529 plans vary greatly in plan structure, options, and benefits, and it is important to properly educate yourself on the state’s and plan’s specific rules for college planning.
Any 529 plan you select will have an offering document that is required to set out the plan’s structure, fees, and investment options as a savings vehicle for college tuition.
For a college savings plan, it is important to look for the kinds of fees the plan charges both upfront and on a continuing basis. The offering document should also set out the kinds of investment options available, such as mutual funds, bank products, stocks, and bonds.
For a prepaid tuition plan, it is essential to read the offering document to understand what guarantees there are for your prepaid credits and what contingencies there are if you end up applying them to a different college.
For both plans, it is also important to consider the state tax benefits and requirements as these vary heavily by state.
Millions of Americans find 529 plans to be an essential tool in saving for college. By understanding the structure, risks, and benefits, you can ensure that you are maximizing its use as a college planning tool.