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This article was fact-checked by our editors and Christina Taylor, MBA, senior manager of tax operations for Credit Karma Tax®. It has been updated for the 2020 tax year.
All parents dream of a bright future for their new baby.
For many Americans, higher education is a path to a better lifestyle, and plenty of parents envision their little ones attending college one day. But how will they pay for it?
The average undergraduate student attending a four-year public institution in their home state will pay $10,560 for the 2020–2021 academic year, according to College Board data. That high price tag helps explain the total amount of student loan debt outstanding in the U.S. — $1.51 trillion at the end of 2019, the Federal Reserve reports.
Yet in the face of those staggering numbers, “only 58% of parents with children under the age of 18 are saving for college,” says Paul Curley, the director of College Savings Research for Strategic Insight, an asset-management data services company. “And that percentage needs to go higher.”
Instead of relying on financial aid, consider starting a qualified tuition plan, commonly known as a 529 plan, for your new baby. It could help ensure you have funds available to pay for their college education down the road. Qualified tuition plans come in two general types: college savings plans, which only states can offer, and prepaid tuition plans, offered by states and qualified educational institutions.
Investing in your child’s education with a 529 college savings plan has its advantages, which may also include some tax benefits. Plus changes to the tax code added elementary and secondary school costs to the list of education-related expenses you can pay with money from a 529 college savings plan.
- What is a 529 college savings plan?
- Tax considerations for 529 college savings plans
- Opening a 529 college savings plan
- When to start a 529 college savings plan
What is a 529 college savings plan?
Sponsored by states, 529 college savings plans are tax-advantaged investment accounts that allow you to invest money toward your child’s education. Generally, you can choose to invest your 529 college savings plan contributions in investment options like mutual funds, exchange-traded fund portfolios or bank products.
As state-sponsored plans, some 529 college savings plans may have residency requirements. So your state’s 529 plan rules may require you use the funds at a college or university within the state that sponsored the plan. Or you may be required to live in the sponsoring state in order to open the account. Though not all 529 college savings plans have these stipulations, so be sure to do your research.
Tax considerations for 529 college savings plans
Among the biggest advantages of 529 college savings plans are the tax benefits associated with them.
While you pay taxes on the money you contribute to these plans, you aren’t taxed on any gains from your 529 investments provided you use withdrawals for qualified education expenses. Plus in many states, you can claim contributions as a tax deduction or credit on your state income taxes.
When you take money out of the plan to pay for qualified education expenses, you don’t pay taxes on those withdrawals. You can generally use withdrawals for qualified expenses at any college or university, and may even be able to use the money for overseas studies.
529 plan rule caveats to be aware of
Keep in mind, if you withdraw money from a 529 college savings plan to pay for non-qualified higher education expenses, you may pay a 10% federal tax penalty on the earnings plus regular state and federal income tax on that withdrawal.
Investigate whether your state offers tax benefits for 529 plans, because many states only offer tax credits or deductions for state residents in addition to waiving certain fees. It’s worth noting that some states will allow residents to deduct contributions even if they invest in another state’s plan.
What education expenses can I pay for with a 529 college savings plan?
Qualified education expenses at eligible institutions can include the following:
- School tuition
- Room and board (if enrolled at least half-time and included in the cost of attendance)
- Books and supplies
- Equipment the school requires students to have
- Computers and internet service
- Computer peripherals (such as printers)
- Education software
Contribution limits for 529 college savings plans
There are technically no specific contribution limits set by the IRS for 529 plans, unlike IRAs or other investment vehicles. However, the IRS does stipulate that “Contributions cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary.”
Also, if your contributions, plus any other gifts, to a particular beneficiary are more than $15,000 in a year, starting in 2018, you could trigger gift taxes.
Some states will set limits, so it’s best to check if the plan you choose has established limits. If it does, and you suspect your child’s education expenses will exceed the plan limits, you may consider opening a second college savings plan in another state to make up the difference. Just be sure the amount you save in both plans doesn’t exceed the amount you actually need for qualified education expenses.
Impact of tax reform on 529 college savings plans
The tax reform law adopted in December 2017 expanded how families can use 529 college savings plans.
Starting in 2018, you can use plan funds to cover up to $10,000 of qualified education expenses for each child you have in kindergarten through 12th grade at a public, private or religious school. The withdrawals you make won’t be subject to federal taxes, but they may be subject to state taxes or penalties, depending on the state you live in.
Things to know about prepaid tuition plans
In addition to college savings plans, a second type of 529 plan is available: prepaid tuition plans.
Prepaid tuition plans are exactly what they sound like — a way to pay college tuition long before your child goes to college. You purchase units that can represent years of enrollment or credits.
Most of these plans are sponsored by states, but some are sponsored by private colleges and universities.
Prepaid tuition accounts basically allow you to prepay future tuition (which is likely to be more expensive than it is now) at today’s rates. The plans offer multiple options for payment and spending (like prepaying in a lump sum or via installments) and options include two-year college, a four-year institution or even graduate school.
Interest your plan gains, and the money that’s disbursed when the beneficiary is ready for college, is tax-free. And in most cases, the sponsoring state will guarantee that the money you invested in your prepaid tuition account will keep pace with tuition — if you purchased units equal to four years of college in 2018, those units will pay for four years of college when your child is ready to attend. You can also switch to another eligible beneficiary if your child doesn’t use the funds.
The biggest limitation of prepaid tuition plans? To gain the full benefit of your investment, you should probably use them in the specific state or school (or group of schools) you’ve contracted with. If you use the plan at a college not covered, you likely won’t get a benefit equal to the amount you would have received if you chose an in-plan college.
And if your child decides not to go to college, no one else uses the plan and you decide to cancel it, you’ll generally only get a refund of the initial amount you paid, minus any interest your money may have earned. You may also have to pay a cancellation fee.
Most state-sponsored plans require either the plan owner or the beneficiary to be a resident of the sponsoring state. Many also have age requirements – you can only purchase the plan for a future college student, not one who’s already in college.
You typically can’t use the units you purchase toward room and board; they’re generally only usable to pay tuition. The plans aren’t federally guaranteed and may not be guaranteed by the state, either.
Finally, with prepaid tuition plans, you have no direct control over the investment. The money you invest is pooled with money from other plan purchasers and invested in long-range vehicles. When the beneficiary is ready to attend college, the plan sends funds directly to the participating institution.
Opening a 529 college savings plan
Start by doing some comparison shopping of different states’ options, especially checking what tax benefits your own state offers.
Consider establishing your plan directly with the state, known as a direct-sold plan, rather than through an advisor or broker, due to the fees brokers charge. You may find that direct-sold plans for your state have lower fees. Additionally, your state may waive fees for state residents, those who keep high balances, those who opt for paperless statements or those who make regular contributions. Check to see what your state offers.
With state-sponsored 529 college savings plans, the state usually selects one administrator. Typically, the administrator is a large well-known brokerage, like Vanguard or Fidelity, that will manage your investments.
Once you’ve chosen a 529 college savings plan, you’ll need your child’s Social Security number and birthdate to open the account. You may have to pay an enrollment or application fee when you set up via a direct-sold plan or a plan with a broker. You may also be required to make an initial contribution.
What’s more, there may be other fees associated with your 529 college savings plan, including for the following:
- Account maintenance
- Program management
- Asset management
Once you begin contributing, you can select your risk profile and begin seeing return on your investments while watching them grow tax-free. Once your child nears college-age, you can opt for a less-risky portfolio. Many plans adjust your portfolio automatically based on age to reduce volatility. If you are looking for someone to help guide your investments, it may be worth going through an advisor and facing the extra management fees.
When to start a 529 college savings plan
You can open a college savings plan at any time. Keep in mind, however, the younger your child is when you open the account, the more time your investment will have in which to grow before you begin making withdrawals for college expenses.
Just like saving for retirement, the magic of compound interest makes putting aside money early on very advantageous. For example, just putting aside $200 a month for 18 years can amount to more than $97,000 given an interest rate of 8% — assuming, of course, that your investments gain rather than lose.
Opening a 529 college savings plan for your baby can be a great way to save toward their eventual college education costs. The money you put in a 529 plan can grow tax-free — whereas you might have to pay tax on gains from other types of investments. Plus if you use the money for qualified education expenses at qualified educational institutions, you may avoid taxes on the withdrawals.
And thanks to changes in the tax code, it’s now possible to put 529 college savings plan funds toward elementary and secondary school expenses.
Keep in mind that, as with any investment, gains are not guaranteed. So your investment could lose money.
However, Curley emphasizes the importance of automating your investment contributions to help you successfully save.
“Consider automatically saving with a 529 college savings plan through payroll deduction or from your bank account, which is what 36% of account holders did last year,” he says. “That way, automatic money going in can help you get to where you want to go regardless of market returns.”
Christina Taylor is senior manager of tax operations for Credit Karma Tax®. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.