I sure wish my family opened a 529 college savings plan for me when I was a kid.
When I graduated from college in 2010, I owed more than $60,000 in student loans, which took me the better part of a decade to repay.
These days, getting an education is even more expensive. According to the College Board, the average cost to attend an in-state public college — including room and board — for four years is more than $85,000. For a private college education, you’re looking at an average of nearly $200,000.
I can’t imagine how expensive college will be when today’s little kids head off to pursue a higher education.
The good news is you can do something about it. But if you want to help your children pay for college, you should try to start saving sooner rather than later.
Let’s take a look one of the great options for a college savings plan — the 529.
- What is the best kind of account to save for college?
- How does a 529 college savings plan work?
- Can I lose money from a 529 college savings plan?
- What happens to a 529 if I don’t use it?
- How much do I need to save for college?
- When should I start a college fund for my child?
What is the best kind of account to save for college?
There are many ways to save money for college but opening a 529 college savings can be a great option.
There are a couple of types of 529 college savings plans:
- Education savings plans
- Prepaid tuition plans
Both can help you pay for college, but in different ways.
Education savings plans
In terms of tax impact, a 529 education savings plan account resembles a Roth IRA. But instead of saving money for retirement, you’re saving money to pay for college.
Depending on the plan your state offers, you may have several investment options to choose from, including mutual funds, exchange-traded funds and target-date funds.
The money you put into your 529 account has already been taxed, and earnings are generally not subject to federal income tax or state tax when used for qualified expenses. Contributions aren’t tax deductible at the federal level but may be at the state level. When you take money out to pay for qualified higher education expenses, you won’t be charged any additional federal income tax on the withdrawn amount.
Prepaid tuition plans
Investing in a prepaid tuition plan essentially lets you lock in the price of a future college education at today’s rates. You can either make a big one-time payment or a series of smaller monthly installments to purchase tuition amounts (in years or credits). You can then use those amounts to pay for future tuition at an eligible college or university.
When your child is ready to go to college, the amount you’ve saved can be used toward your child’s education at a qualifying school.
How does a 529 college savings plan work?
If you’re trying to figure out which 529 college savings plan is right for you, it might help to learn more about how these plans work.
What colleges can my kid go to?
When it comes time to pick a college, 529 education savings plans may be more flexible than prepaid plans.
A 529 education savings plan can be used at most colleges and universities, including public schools, private schools, out-of-state schools and some foreign schools. You can even use up to $10,000 per year to pay for a public, private or religious high school or elementary school.
By contrast, 529 prepaid tuition plans are geared toward students who attend school in their home state, so your children may be at a disadvantage if they attend an out-of-state college or university or a private school.
What sort of expenses does a 529 cover?
Both 529 college savings plans can be used to pay for tuition and qualifying fees.
But an education savings plan will typically allow you to pay for more qualifying school-related expenses, like room and board, books, internet access and a school-related laptop or tablet computer.
What are the tax benefits?
The money in a 529 education savings account grows tax-free. So when your child withdraws the money to pay for qualified education expenses, no federal income taxes or — in many cases, state income tax — will be due.
The same thing goes for a 529 prepaid tuition plan. You fund the account with after-tax contributions, and no federal income tax or state income tax (in many cases) is owed when your child withdraws the money to pay for college.
But, unfortunately, contributing to either type of 529 plan may not help you save much money on taxes next April. You can’t deduct contributions from your federal income taxes, but you might be able to earn a state tax deduction, depending on your state.
Are there any contribution limits or income limits?
Regardless of how much money you make, the federal government doesn’t place any income restrictions on who can open a 529 college savings plan.
There’s also no defined contribution limit. Just keep in mind that if you invest more than your child needs to pay for qualified education expenses, your child might have to pay income taxes on any withdrawals that aren’t used to pay for college.
How will this affect my child’s financial aid package?
When your child applies for need-based federal aid, both their assets and your assets (including things like savings accounts) can be considered when determining the amount of the Expected Family Contributions. The EFC is the amount your family is expected to kick in for college education costs.
Your assets, including education savings, are included in that calculation, and can reduce the amount of financial aid available to your child.
Can I lose money from a 529 college savings plan?
If you want to help your children pay for college, it’s important to start saving when they’re young. But no matter how much you set aside, there’s always the risk that your 529 education savings plan could lose money, if …
- You take an unqualified withdrawal, or
- The financial products your 529 is invested in decline in value
Although you can take your money out of a 529 education savings plan for any reason, if you withdraw the money for anything but an approved education expense, you may be required to pay state and federal income taxes plus a 10% federal tax penalty on any gains.
You could also lose money from your 529 education savings plan if the market declines, because it’s an investment account whose value can fluctuate. Your 529 is not guaranteed by state government and may not be guaranteed by the federal government, though investments in some principal-protected bank products may be insured by the FDIC.
“As with most investments, investments in education savings plans may not make any money and could lose some or all of the money invested,” according to the Securities and Exchange Commission.
What happens to a 529 if I don’t use it?
We applaud you for trying to prepare your child for a bright future.
But there are several reasons why your child might not use all of the money in a 529 college savings plan.
- Your child doesn’t go to college
- Your child’s higher education expenses are less than you expected and you have leftover money
- Your child gets a scholarship
- Your child joins the military and their tuition is covered
Rest assured, you won’t lose all the money in your 529 college savings plan just because your child doesn’t use it to pay for college.
If your child doesn’t go to college, here are a few options for what you can do with your 529.
- You could wait to see if your child goes to college later in life.
- You could switch the beneficiary to another family member who needs help paying for college.
- As the account holder, you could also name yourself as the beneficiary to pay your expenses if you go back to school.
If all else fails, you could close the 529 college savings account and cash it out. Unfortunately, you’ll likely have to pay federal and state income taxes, plus a 10% federal tax penalty on your gains. But at least the money won’t be a total waste.
How much do I need to save for college?
You might be wondering, “How much money should I save for college?”
That depends on what sort of education you want to provide for your children. Do you plan to send them to a private school across the country, or will they attend a public school in-state? Do you expect your children to contribute? Will you only pay for tuition, or will you also cover room and board?
When you figure this out, take a look at how much that would cost in today’s dollars. According to the CollegeBoard, here is the average published cost of tuition plus room and board during the 2018 to 2019 school year.
- Public (in-state): $21,370 per year
- Public (out-of-state): $37,430 per year
- Private: $48,510 per year
Unfortunately, there’s no way to know exactly how much it will cost to go to college in 18 years, but the Financial Industry Regulatory Authority, or FINRA, has an education savings calculator that helps you estimate the amount to invest each year to have enough money to cover your anticipated future college costs.
Let’s assume you open a 529 education savings plan for your baby, who will attend a four-year college in 18 years. The account grows at 7% each year with an annual inflation rate of 2%.
Based on FINRA’s education savings calculator, here’s the estimated amount you’ll need to contribute to your plan at the beginning of each year, based on the average cost of tuition, room and board during the 2018 to 2019 school year noted above.
- Public (in-state): $2,844.58 (for a total of $103,482.84)
- Public (out-of-state): $4,982.34 (for a total of $181,252.36)
- Private: $6,457.21 (for a total of $234,906.54)
Or, if you look at it another way, it will cost about $237 each month for the next 18 years to send your kid to an in-state public school, $415 per month for an out-of-state public school, and $538 per month for a private school.
Just keep in mind that these are estimates and that the actual costs may vary. If you’re looking for a more precise number, you might want to consider investing in a 529 prepaid tuition plan, where you can purchase future college credits in today’s dollars.
When should I start a college fund for my child?
When it comes to saving for your child’s college education, the sooner you start, the better. Not only does starting early give your college fund more time to grow, but it also can allow you to reap the benefits of compound interest.
Vanguard provides an excellent example of how compound interest makes an early start valuable. According to the financial services company, if you start saving for college when your child is born and invest $25 per week at 6% annual interest for the next nine years before stopping — a total investment of $11,700 — your fund will total about $26,750 when your child’s ready to go to college at 18. But if you wait nine years before beginning to save, and all other factors remain the same, you’ll have a fund of only about $15,800 by the time your child is 18. The stark difference is due to compound interest.
What is compound interest?
Compound interest is interest calculated on the entire balance of an account — including both the principal amount borrowed, invested or saved and the interest already accrued on the principal. Compound interest can help savings grow faster, or unpaid debt accrue interest charges faster. Learn more about compound interest and how it works.
A 529 college savings plan is just one way to save money for college. Other options include educational savings accounts, custodial accounts and savings bonds. But 529 savings plans offer some attractive advantages, including the ability to make investment choices, no age limit on plan beneficiaries, federal tax-deferred earnings and tax-free withdrawals (as long as they’re for qualified educational expenses).
Saving for college might be challenging, especially if you’re working to pay off your own student loan debt. But saving for your child’s college education early could help them avoid having to face a mountain of hard-to-manage student debt.