With the school year right around the corner, now is a good time to start thinking about college savings.
Have you heard about the 529 college savings plan? Are you curious if you should get started with one?
I’ve had some questions come in lately regarding saving for education expenses using a 529 Plan. I thought I’d take today to attempt to answer a few. Hopefully this will get you more comfortable with the account so you can start funding one for your kid’s college education.
What is a 529 Plan?
A 529 Plan is a savings plan for educational expenses (named after the Federal tax code) set up by individual States or institutions. They’re designed so that you are encouraged to help save for your child’s education (college or trade school). The encouragement comes in two forms: the ability to save money free from Federal taxes and the ability to receive a deduction on State taxes.
The 529 Plan is really the Roth IRA of the college savings world. Meaning, your savings grows tax-deferred and the withdrawals are tax-free as long as you use them for qualifying educational expenses. 529’s are a really good deal.
What About Prepaid vs. Savings Type Plans?
529 Plans usually come in two types: prepaid and savings. It’s important to know the difference. Some States offer one or the other, both, or a plan that combines the features.
Prepaid 529 Plans usually give you more tax benefits and college discount for schools in that particular State. The prepaid plans are considered inflation-busting, since they allow you to save for college at today’s prices.
But they also come with more restrictions. For instance, if you decide to use a prepaid plan in your State and then later send your child to a college out-of-state you’re going to forfeit some of the savings you were able to get by being in an in-state prepaid plan. This varies greatly by State plan.
529 Savings Plans are more flexible. You can usually use these types of plans at any accredited college or university in the Country. I’m a resident of Texas and have a 529 Savings Plan with Ohio’s CollegeAdvantage Program. Since it’s a savings-type plan, I can use the funds where ever I want, as long as it’s for qualifying education expenses.
What if my child doesn’t end up going to college?
The savings and earnings from the savings are always your money. The donor (you) always maintains control over the funds. The beneficiary (your child) has no control. You can switch beneficiaries at any time (typically once a year).
So, if your first kid doesn’t go to a qualifying institution, then you can switch the plan beneficiary to another child, yourself, or whoever. Or, you can withdraw the funds. There is generally no limit to how long keep the funds in the 529 plan account.
The only thing that you may forfeit for not using the funds for educational spending is the tax savings on the funds, and a 10% penalty on the earnings from the savings.
As an example, let’s say:
- You deposit $50,000 now into a 529 Plan.
- Fast forward 18 years and your funds are now worth $60,000. You’ve earned $10,000!
- Let’s assume your child decides to skip college.
- If you withdraw those funds and use them for yourself on Twinkies, the $10,000 would be subject to the tax and the penalty.
- You’d roughly owe the Federal Government $3,000 to $4,000. You’d walk away with around $56,0000 of your $60,000.
But, the 10% penalty can be waived if your child becomes disabled, dies, or gets a scholarship.
What if my child gets a scholarship to college, then what happens to the 529 Plan funds?
Like I said above, you generally have a few options: transfer to another beneficiary and give it to them, sit on the funds until another option becomes available, or withdraw the funds penalty-free (you just have to pay the taxes). The penalty is waived if your child gets a scholarship though.
Should I open a separate 529 account for each child or should I have just one account?
Yes, open an account for each child. To my knowledge you can only have one beneficiary of the funds from an account.
Do I have to use my State’s 529 Plan?
No. But there may be a good reason for you to. Typically the savings in State taxes is the biggest factor. The best guide I’ve found for helping me determine this is Kiplinger’s Best 529 Savings Plans. They will tell you if there’s a reason to stick to your State’s 529 Plan or go with a top 5 plan from another state.
Can you withdraw 529 Plan funds for an emergency with or without pentalty?
Generally, you have complete control over the funds in the plan. You can withdraw your funds at anytime, for any reason. As I mentioned above though, you’d be subject to a tax and penalty on the earning from the savings. There is no hardship rule that I know of that would exempt you from the penalty.
What age or when do you HAVE to withdraw the 529 Plan funds?
There generally is no age or time limit for withdrawals.
Could the 529 Plan act as a nest egg fund for my children?
Using the 529 Plan for anything other than educational expenses would be an inefficient use of the plan. If you’re looking for a place to stash some emergency savings, consider an FDIC insured high-interest savings account.
Should I consult a CPA, CFP, and understand the plan I’m getting into?
This is advised, but it’s not absolutely necessary. If you’re unsure about opening up a 529 plan, please visit a fee only financial professional to understand your full range of college savings options. There are other options like Coverdell ESAs that might be a better for your situation.
Another reason to consider working with a pro is that each State plan and tax implications have an impact on your decision. Lastly, take time to research the plan you’re getting into. Read the guidelines of the plan. Call up your State’s plan administrator and have them explain it to you.
Good luck getting started with your college savings!
Photo by cogdogblog