According to the National Center for Education Statistics, undergraduate tuition, room, and board at public institutions rose from $13,561 in 2007-2008 to $17,979 in 2017-2018, amounting to a 31% increase. The cost of attendance at private institutions rose 23% during the same 10-year period, from $34,890 to $42,681. The increasing cost of college education may discourage students from getting a degree.
In an effort to boost college attendance by making it more affordable, the federal government administers several scholarship and grant programs. In addition, each state maintains qualified tuition plans, which are tax-free programs that help cover the cost of college education. This guide focuses on 529 plans, but it also includes other ways that students can save for college.
A 529 plan is a “tax-advantaged savings plan designed to encourage savings for future education costs.” Each state, plus the District of Columbia, sponsors at least one type of 529 plan. Some higher education institutions also sponsor prepaid tuition plans.
Prepaid Tuition Plans vs. Education Savings Plans
Type 1: Education Savings Plan
An education savings plan allows savers to open an investment account for a beneficiary’s future educational expenses. Account owners can use withdrawals from this plan to pay for college tuition, fees, and room and board. They can also use it for elementary and high school education, usually up to $10,000.
As long as withdrawals are used to pay for qualified educational expenses, account holders do not pay taxes on the interest their money accrued during the time it was invested. This type of 529 college savings plan does not typically maintain a residency requirement.
Type 2: Prepaid Tuition Plan
People with prepaid tuition plans purchase units or credits from participating institutions, which are often public in-state colleges and universities. Funds from this type of college savings plan can only pay for tuition and fees and do not cover room and board. Prepaid tuition plans often require participants to be residents in the sponsoring state.
Savers can only use funds from prepaid tuition plans for higher education tuition and fees. They cannot use them for elementary or high school expenses. Beneficiaries who enroll in a non-participating institution may receive less than they would have received if they enrolled in a participating school.
5 Benefits of a 529 Plan
You get a tax break
Tax regulations governing contributions to a 529 college savings plan differ among states. However, states typically regard 529 plan contributions as tax deductible. Savers should keep in mind that local and state laws regarding college savings plans may change over time.
Contributions are considered gifts
As of 2021, a 529 plan can receive contributions of up to $15,000 each year from non-account holders. As long as individual contributions do not exceed this amount, plan beneficiaries qualify for the annual gift tax exclusion. Contributors often include grandparents and other close family relatives.
The person who opened the account controls the account
Only the person who opened the 529 plan can make changes to the plan. Account holders can also borrow against the plan, make an early withdrawal, and close the plan entirely.
Minimal impact on financial aid eligibility
Students must declare a 529 plan as part of their assets when they file the FAFSA. Schools and financial aid administrators often require this information when calculating a student’s expected family contribution. However, institutions usually only factor in a small percentage of the 529 plan in the final calculation of student aid. As such, it often has minimal impact on the amount of financial aid students receive.
Funds can be used at most higher education institutions
Beneficiaries can often apply the funds from a 529 college savings plan toward any accredited institution, including community colleges and technical schools. Prepaid tuition plans may limit use of the funds to participating in-state institutions. Some education savings plans allow students to apply their 529 plan benefits toward international schools.
The steps required to open a 529 plan differ among states and host institutions. In general, however, opening a college savings plan includes the steps outlined below.
Step 1: Choose a State
Individuals who open a 529 plan in their state can take advantage of the income tax benefits from their contributions to the plan. Although some 529 plans have restrictions, most plans allow savers to apply their benefits toward any in-state or out-of-state institution that meets the plan’s eligibility criteria. Tax regulations related to college savings plans vary among states. Savers should research the regulations in their state to learn more.
Step 2: Choose a 529 Plan Type
Potential savers should consider their individual circumstances before deciding on a type of 529 plan. For example, couples with young children may benefit from an education savings plan that can easily accommodate life changes. A prepaid tuition plan may benefit families with children closer to college age since they might have a clearer idea of what college or university their children will attend.
Step 3: Complete the Application
A person can often apply for a 529 plan on the plan’s website. To open an account, savers typically must submit their name, mailing address, date of birth, and the Social Security numbers of the account owner and beneficiary. Some plans ask for the name and information of a successor account owner in case the original account owner dies or becomes incapacitated.
Step 4: Make a Contribution
Account owners can contribute to a college savings plan in many ways, including automatic payments from a linked account, payroll deductions, and checks. The IRS does not set contribution limits for 529 college savings plans. However, each state sets a maximum aggregate limit. This amount cannot be more than the beneficiary’s expected cost of college attendance.
Step 5: Choose Your Investments
Account owners can usually choose the investment instruments for their 529 plan contributions. This can include mutual funds and static and target-date portfolios. States do not guarantee 529 plans. A 529 plan may earn interest or lose value, depending on the performance of the portfolios it contains. However, the FDIC may insure investments in some principal-protected bank products.
Virginia529 (open to WY residents; no in-state 529 program currently offered)
Other Ways to Save for College
A 529 plan offers several advantages. However, parents and guardians can also explore other ways to pay for college, including the four options described below.
Coverdell Education Savings Accounts
People with a Coverdell Education Savings Account can use the funds to cover elementary school, high school, and higher education expenses. This type of account is a custodial account. It’s strictly for beneficiaries younger than 18 years old at the time of opening the account or beneficiaries with special needs status. Account holders can only contribute to the fund in cash. Contributions cannot exceed $2,000 per year, and contributions are not tax deductible.
Bond owners who redeem eligible U.S. savings bonds to pay for qualified higher education expenses can exclude the interest paid on the withdrawn amount from their taxes for that year. Bond owners who use withdrawal funds for non-education expenses cannot access this exclusion. Only savings bonds issued before the owner was 24 years old qualify for this exclusion. The exclusion covers educational expenses for the bond owner, their spouse, and legal dependents.
Parents can set up a custodial account for their children under the Uniform Gift to Minors Act without the need for an attorney to prepare trust documents. The account is only subject to state regulations. The Uniform Transfer to Minors Act allows beneficiaries to own other types of assets, such as real estate, fine art, and patents. The main difference between a 529 plan and a UGMA/UTMA custodial account lies in the manner beneficiaries can use the funds upon withdrawal. Beneficiaries can only use 529 plan funds to cover education expenses. Beneficiaries of a UGMA/UTMA custodial account can use the money for any purpose.
Since a Roth IRA is funded with after-tax dollars, account owners cannot claim a tax deduction on their contribution. However, the IRS does not tax withdrawals from a Roth IRA. The government imposes income and annual contribution limits for Roth IRAs, which often change. Although a Roth IRA is a retirement account, owners can use the funds for any purpose, including education expenses for their dependents.
Mark Kantrowitz is a bestselling financial author, with books discussing financial aid, saving for college strategies, and student loans. His career and experience as a publisher and vice president of research at Savingforcollege.com make him a sought-after expert in financing higher education. Mr. Kantrowitz offered the following tips on saving for college:
1. Start as early as possible
“Time is your greatest asset. The sooner you start, the more time you have for your earnings to compound,” Kantrowitz says. “Start saving as soon as possible, when the child is born. In fact, start saving before the child is born.” Parents and guardians can get a jumpstart on saving for their child’s future education by opening a taxable savings account and transferring those funds to a 529 plan later on. They can also simply open a 529 plan with the account holder listed as the beneficiary and later change the beneficiary to the child.
2. Set-up automatic payments
“How do you go about saving? The first thing you need to do is make it automatic so you don’t have to take an action every single month in order to save,” Kantrowitz explains. People often forget to make a contribution, or they may spend the money for other purposes if it is not automatically withdrawn. “Every 529 plan has an automatic payment option. Some plans even have payroll deductions for participating employers. The minimum amount that you need to contribute per month to sign up for automatic investment is typically around $25.”
3. Save what you can
“Every dollar saved is a dollar less you’re going to have to borrow. And college savings plans are the antidote to student loan debt. If you were to save one dollar per day, you would accumulate, between the interest and the contributions, about $10,000 by the time the child enrolls in college,” Kantrowitz stated. In addition, it’s wise for parents to deposit lump sums from tax returns, work bonuses, and other monetary surpluses into their child’s 529 account when possible.
4. Incrementally increase your contribution amount
“Ideally, your college savings goal should be to save a third of the future college cost. When we break it up into monthly amounts, it’s more attainable. Some people can’t afford $250 per month, so you start low and gradually increase it.” Kantrowitz recommends reallocating old expenses, such as diaper costs, to increase monthly contributions to 529 plans and to make more mindful decisions when spending.
5. The market fluctuates; learn to manage risks
“You can’t avoid the potential for losses; what you can do is manage it, and that’s why age-based asset allocations are a good choice. Even if you have a big loss at the beginning, you have 17 years to recover. ” According to Kantrowitz, choosing an age-based asset allocation plan allows account holders to take greater investment risks earlier in the savings process, giving investors plenty of time to bounce back and regrow funds after any economic downturns.
6. Follow an age-based asset allocation strategy
“Within the 529 plans, you have a bunch of different investment opportunities. I recommend doing an age-based asset allocation. It starts off aggressive, and as the child gets closer to college, you can shift to a more conservative mix of investments,” said Kantrowitz. Ideally, account holders begin by investing 80-100% of funds in equities, and gradually reduce that percentage to around 20% as the child nears college.
7. Choose the lowest account fee plan for young beneficiaries
When deciding which type of plan to buy — a plan with the lowest fees or a plan with the best tax incentives — Kantrowitz recommends investors focus on the lowest fees when the child is young. Direct sold plans eliminate the financial mediary of an advisor plan and come with fewer fees. However, some people may find peace of mind through an advisor plan, as there is a financial professional on your side to help calm the storm during stock market turmoil.
8. Avoid investing in individual stocks
“Investing in individual stocks, in many cases, is just far too risky. You might as well go out and buy a lottery ticket. What you want to do is invest in broad-based mutual funds, like an S&P 500 fund,” Kantrowitz advises. Choosing these funds follows the broad trend of the market, offering a greater probability of success than investing in individual stocks. Individual stock investing is the financial equivalent of putting all your eggs in one basket.
9. Consider investing in your home state
“I think you should always consider your own state’s 529 plan. There may be other benefits, like matching contributions or seed money for saving in your own state. Thirty-four states and the District of Columbia offer a state income tax deduction or tax credit on your contributions to the state’s plan.” If the tax rate is 5%, that’s like getting a 5% discount on tuition, Kantrowitz explained.
10. Start and stay aggressive
While Kantrowitz recommends age-based asset allocation plans, he also has some suggestions for improvements: “I think people move off of the high percentage equities too quickly. I think that maybe you should spend 5-10 years in 100% equities, then switch to age-based allocation.” This aggressive strategy may yield greater profits early on to grow funds quickly.