Why is a 529 college savings plan important? Consider that the average cost of a college education is $32,405 at a private college, according to the College Board’s latest survey for the 2015-2016 school year. That’s 26 percent higher than it was decade ago. And 10 years from now, it’s likely to be higher still.
A 529 plan allows you to save for that coming bill in a tax-advantaged way and avoid interest on loans.
What Is a 529 plan?
Today, every state in the U.S. offers at least one 529 plan. While the way plans are structured may vary, they are generally categorized two ways:
Savings: Typically provided by the state, a qualified college savings plan offers a lot of flexibility. There are no income requirements or age limits to open the plan. By contrast another college savings vehicle, Coverdell ESAs, have income and phase-out limits that leave high-earning taxpayers ineligible for tax advantages.
Much like a 401(k) plan or IRA, contributions to savings-based 529 plans typically go into a portfolio of stock and bond offerings. The range of options depends on the individual plan.
The specific rules for 529 college savings plans vary from state to state. Generally, you may open an account in any state you'd like. Plus, anyone can contribute to the 529, from parents and grandparents to other relatives and friends. You can even open an account for yourself if you want to go back to school.
Each state sets the lifetime contribution limit for its respective 529 plan, generally between $100,000 and $270,000. Initial minimum investments can be as low as $25 per month.
Prepaid: These 529 plans provide parents the opportunity to pre-purchase tuition to a specific university or group of universities based on today’s rates. Essentially these plans are a play against inflation, allowing the purchase of school attendance now in anticipation of higher costs later. Typically administered by states, higher education institutions or not-for-profit organizations, prepaid tuition plans are not offered everywhere.
It’s possible to use the funds in a prepaid plan to attend a school not in its network, but there might be a penalty depending on the particular 529 plan’s rules.
Whether you choose a college savings or prepaid tuition plan, there’s one important thing to keep in mind: Withdrawals from 529 plans must be used on qualified higher education expenses. So what is considered a qualified expense?
To gain the maximum advantage of a 529 plan, you can only spend your college savings funds on qualified higher education expenses. These include:
- Room and board (for students enrolled half-time or more; includes off-campus rent)
- Mandatory fees
- Books and supplies
- Equipment required for enrollment (such as a computer)
Make sure to check the list of qualified expenses at your beneficiary’s institution. They don’t always include items that may seem necessary, like clothes or transportation. Even a computer is not eligible unless the school has a written policy requiring it for attendance. Fortunately, that requirement is becoming more common across the country.
The tax advantages of 529 plans are one of the main reasons so many people invest in them. Earnings in a 529 plan grow tax-deferred and withdrawals are free of federal income tax when used for qualified higher education expenses.
But if you use the money in your 529 account for non-qualified purposes, the earnings portion of the withdrawal will be subject to ordinary federal income tax, plus an additional 10 percent federal income tax, and any applicable state income tax. It’s important to note that not all states offer a state income tax deduction for a 529 college savings plan. To find information on your state, visit savingforcollege.com.
When planning and budgeting for your college savings, remember that qualified expenses are the majority of the cost of college. While everyone’s needs and situations vary, one strategy always applies: Every dollar you save today gets you a little closer to your college-savings goals.
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