529 Plans: What They Are and Why You Want One

Before you know it, it’ll happen — your kiddo will start looking at colleges. Whether your child is six months old or 12 years old, now’s the time to start planning for the future.

The average annual cost (tuition, room, board and fees) was $21,370 for a 4-year in-state public university and $48,510 per year for a 4-year private college in 2019, according to USA Today.

By the time today’s tiny babies spread their wings, the average cost of a four-year private education could be $302,700.

Yikes. Overwhelming, huh?

It can be tough to get past the mind-numbing numbers and the blind panic you may feel about choosing among endless college savings options. Get started with a 529 plan as soon as you can. (No, you’re not “behind” if your child’s older!)

Here’s how to get started.

What is a 529 plan?

You’ve probably already heard of the words “529 plan” but what is a 529 plan, exactly? Put simply, a 529 plan, legally known as a “qualified tuition plan,” is a college investment plan that offers tax and financial aid advantages.

You’ll be able to find two different types of 529 plans: prepaid tuition plans and education savings plans. All 50 states and the District of Columbia sponsor at least one type of 529 plan.

The major benefit to 529 plans? Tax advantages — no question about it. 529 plans offer tax-free investment growth and withdrawals for approved expenses like tuition, books, room and board. They’re completely free of federal income or capital gains tax.

They’re also flexible. This means you can transfer them from child to child (also called your “beneficiaries”), there are no income or age restrictions and the upper limit on annual contributions is typically about $300,000, though this amount varies by state. In contrast, the Coverdell ESA, another college savings option, limits contributions and restricts eligibility to specific income levels.

A few things to note about 529 plans:

• Funds must be used for qualified educational expenses.

• You’ll pay fees for each type of plan.

• You’ll also encounter some ownership rules. The owner of the account (not your child!) gets to make decisions about how the money is used.

Prepaid tuition plans

A prepaid tuition plan allows you to buy units or credits at colleges and universities that participate in your state’s prepaid tuition plan. In other words, you lock in today’s rates for tomorrow. What do the units or credits go toward? Tuition and fees only — not room and board.

Most states offer you a promise — that a prepaid plan will keep pace with tuition. In other words, prepaid tuition plans are financially backed by most states.

Some states offer no guarantees that the plan will fund the future cost of tuition or that the state will step if the plan can’t cover costs, however.

Education savings plans

The other type of plan, an education savings plan, lets you open an investment account to save for your beneficiary’s future qualified higher education expenses. Qualified higher education expenses include tuition, room, board and fees.

You can use an educational savings plan at any college or university and you can even pay for tuition at any public or private elementary or secondary school.

Pros and cons

As with most types of investments, there are pros and cons. Let’s dive into the nuances of each type of investment.

Prepaid tuition plan pros

• You get a locked-in rate. Tuition continues to skyrocket, so locking in a tuition rate gives you the best chance of keeping things absolutely steady.

• You don’t need to make specific investment decisions. Trying to figure out the benefits of one mutual fund over another? Don’t stress. You’ll sidestep having to make decisions about risk tolerance, asset allocation and all that… stuff… with a prepaid tuition plan.

• You’re not at the mercy of stock market fluctuations. Unlike an education savings plan, you’re not investing in the stock market and crossing your fingers that the markets will behave perfectly during all your years of saving.

• You’ll still find flexibility with in-state options. You can transfer pretty seamlessly from one in-state option to another if your child decides to go to a different college within state boundaries.

• You can transfer to siblings. It’s okay to transfer prepaid tuition from child to child.

Prepaid tuition plan cons

• State-based options can be limiting. 529 plans are state-based, which means your child can’t go out of state for college.

• Your investment isn’t guaranteed by some states. If your plan hits a shortfall, your child might be out of luck. Make sure each plan is backed by a guarantee before you elect to participate.

Education savings plan pros

• Several investment options are available to you. You can choose an age-based plan that will grow more conservative as your child grows older — a popular option so you’re not taking on risky investments when your child is in high school.

• There’s no residency requirement. You can use your 529 education savings plan wherever you want, even if your child lives in Iowa and wants to go to school in Massachusetts.

• The contribution amount is up to you. Maximum limits range from approximately $200,000 to $400,000, depending on the state in which you live.

Education savings plan cons

• You won’t experience a lock on tuition rates. Unlike prepaid tuition plans, you won’t get to lock in college tuition for the future. This means that you’ll pay whatever the tuition amount is whenever your child enters college.

• Your money is exposed to risk. You’ll be subject to the whims of the stock market. Fortunately, if you choose

What are the Contribution Limits?

As noted earlier, total 529 plan contribution limits are set by each state and can tip up to $400,000 per year. However, you’ll need to consider federal gift tax as you make contributions. Federal law allows single taxpayers to contribute up to $15,000 in 2020 (or $30,000 for married couples filing jointly) without paying gift tax.

You can also “superfund” a 529 plan, which means you can contribute up to $75,000 (or $150,000 for a married couple) as if you had applied it over a 5-year period.

What are the Withdrawal Rules?

You can withdraw money from a 529 plan at any time for any reason. However, you’ll pay both a 10 percent penalty and ordinary income taxes on the earnings if you don’t spend the money you’ve saved on qualified higher education costs.

If your child doesn’t attend a participating college or university, prepaid tuition plans specifically may pay less than if your child attends a participating college or university.

How to Open a 529 Plan

When should you open up a 529 plan? Quick answer: As soon as possible, to take advantage of compounding interest!

Step 1: Choose a 529 plan.

A common misconception is that you can only invest in your state’s 529 plan, which isn’t true. However, many states offer a state income tax deduction or tax credit on contributions to your own state’s 529 plan. Residents of Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana and Pennsylvania can even get a state income tax break for contributions to any state’s 529 plan.

Take a look at 529 plan performance, take a peek at the fees and learn as much as you can about all the different options.

Once you’ve decided on a plan, enter your information on the plan’s website, your beneficiary information and you’re set.

Step 2: Fund your account.

Decide how much you’d like to contribute to your child’s college education per month, then make it automatic. Use Investor.gov’s savings goal calculator and use the past performance of the fund you’ve chosen to determine your estimated interest rate.

You can get started with many plans for a very low amount — just $25 could kick-start a plan!

Step 3: Choose investments.

The easiest way to choose investments is to opt for an age-based portfolio that corresponds to your child’s age. These portfolios are a handy way to blitz right toward an age-appropriate, diversified investment that becomes more conservative as you child’s ready to head off to college.

Many plans also offer target-risk or individual portfolios — they let you tackle a DIY approach. If you’re a savvy investor, you may want to choose that option. If not, don’t sweat it and stick with the age-based portfolio option. You can change it later, but know that by law, you can only make two 529 plan investment changes during each calendar year.

Step 4: Make it automatic.

Opt for automatic investments in your plan. It’s one of the best ways to guarantee that you’ll continue to fund your child’s 529 plan without fail every month. You might not even miss the amount that comes out of your account every month!

Step 4: Make a withdrawal when it’s time!

Once your child has made a decision — and hopefully he or she can! It’s pretty easy to make a withdrawal to the 529 plan you’ve saved money in over so many years! First, evaluate how much your child is getting in scholarship or grant money and subtract that from the amount you plan to withdraw from your 529 plan.

Next, call your plan administrator, make a request online or you can even submit a withdrawal request form. The account owner, the beneficiary or the school can receive checks.

This process can take between three and five business days. Don’t wait till the last minute — you want to be sure payments arrive on time! Also, make sure you really understand what qualified expenses are!

Choose the best 529 plan for your needs (and your child’s!)

Remember the wise Chinese proverb: “The man who moves a mountain begins by carrying away small stones.”

You can do it — step by step, by saving just a little at a time. Best of luck!