If you’re looking into saving for your child’s college education, you may have heard of 529 college savings plans. But what are these plans, what are the benefits, and are they the right options for you and your family? Here’s what you need to know in a nutshell.
What is a 529 Plan?
A 529 plan is a savings plan for college educational expenses. They are usually sponsored by an individual state so there are many 529 plans out there to choose from. In general these plans are meant as an investment vehicle to help facilitate saving for future educational expenses while maximizing tax savings and minimizing their impact on financial aid qualifications.
What are the benefits?
As mentioned above, perhaps the greatest benefit of a 529 plan is the potential for tax savings. Unlike most other savings options, a 529 plan allows for tax-free contributions to the plan as well as tax-free growth. In other words, you can have the contributions deducted directly from your paycheck and put into the savings account so that you can avoid taxes upon deposit. Additionally, the money you earn on those deposits for the period of time they were invested can be withdrawn without paying tax as long as you use any withdrawals for qualified educational expenses.
Depending what state you live in, the contributions to your 529 plan may be deductible on your state tax return an addition to your federal tax return. For instance, my husband and I currently have a 529 savings plan that is sponsored by the state of Nevada. We chose that account as it is one of the best rated 529 plans for several years running as ranked by Morningstar. We actually live in Pennsylvania, however, which is one of several states that allows us to deduct our contributions even if we invest in a plan sponsored by a state other than the state we reside in.
What are the drawbacks?
The largest drawback of any 529 plan is that it is specifically designed to pay for the costs associated with higher education. While this can include vocational training in addition to a traditional college degree, should your child choose to forgo higher education, these funds cannot be repurposed for non-educational expenses without incurring a 10% federal penalty. However, the funds can be put toward the education of several different family members including your grandchildren or even yourself, so chances are someone will be able to benefit from these savings to further their education.
Are there other options for college savings?
There are obviously many ways to save and invest money, though none are so specifically dedicated to educational expenses. Roth 401(k)s and Roth IRAs are probably the most comparable options. Both are valuable ways to save since education expenses (depending on the plan) are often an exception to the typical early withdrawal penalty. However, the biggest difference is that while your investment can grow tax-free, your contributions will still be taxed. Not only does that mean you will have to pay more in taxes, but there are also significant limitations to how much you can contribute per year. The overall benefit of these plans, however, is that they are not required to be spent on educational expenses, so if you do not need them to pay for higher-education costs, you can simply leave your investment in the account until you qualify to take distributions for retirement.
Hopefully this provided you with a good basic understanding of how 529 plans can fit into your financial plans. Obviously we are just scratching the surface on college savings plans, so if you have any specific questions relating to this topic, please feel free to leave your questions in the comments section or send us an inquiry. We want to know what you’re thinking!
Written By: Lindsay Dell Cook
Lindsay Dell Cook is a CPA, writer, and founder of Budget Babble. She lives in Philadelphia with her uber supportive husband, and enjoys taking their adorable mutt for walks or reading a good book while buried under a pile of cats.