The 411 on 529 Plans

By Susan TaylorAugust 4th, 2016Budgeting and Saving Money

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The College Board reports that the average total tuition and room and board charges for an in-state public college were nearly $20,000 for the 2015-2016 school year. As costs skyrocket, parents who want to cover at least some of these expenses need to plan ahead and start saving as early as possible. One of the most popular ways to do this is with a 529 college savings account.

Similar to how a Roth Individual Retirement Account (IRA) lets you save money now and spend the earnings and withdrawals tax-free in retirement, a 529 account lets you set aside money now and spend the earnings and withdrawals tax-free on college expenses. (A new type of account called an ABLE account now allows individuals with disabilities and their families to save money in a tax-advantaged account similar to a 529.)

Parents can set up a 529 account with a child as the beneficiary. It’s preferable to make the student the beneficiary and not the owner, because a student owning a 529 can limit their financial aid eligibility; many colleges look more favorably on a parent owning a 529. Other relatives can contribute to the account as well, adding small amounts on a regular or sporadic basis. To help simplify the process, contributions can be automated similar to how you can automate retirement contributions.

How It Works

Money in a 529 is invested and grows without federal income tax implications. Many plans offer age-based portfolios that invest in a mix of stocks, bonds, mutual funds and other vehicles based on your child’s age so that you can set it and forget it. Just as an age-based retirement portfolio gets gradually more conservative in its investments as you approach retirement age, age-based 529s adjust their investment mix as your child gets closer to attending college.

Money in a 529 can be spent on qualified college costs including tuition, room and board, textbooks and mandatory fees. If you spend that money on expenses unrelated to college, it loses the tax benefit and may be subject to an additional 10 percent penalty. However, you can always change the account’s beneficiary. If one child decides not to attend college or gets a full scholarship, a sibling or other relative can use that money for college tax-free or a parent could choose to go back to school.

These accounts are sponsored by states, and your state may have state income tax incentives (on top of the federal income tax benefit) if you choose to invest in one of your state’s 529 plans. However, you can invest in any state’s plan regardless of where you live. State plans vary in their investment options and fees, so you’ll want to research your options and choose one with low fees. In general, actively managed funds will tend to carry higher fees than index funds. Each state has its own contribution limits (usually up to several hundred thousand dollars), and there are no income limits on who can contribute to a 529.

You can open multiple 529 accounts in multiple states, but with money spread over several different accounts, it’s harder to keep of track your accounts and ensure a diversified portfolio that fits your risk tolerance and time horizon.

Some Considerations

However, before parents funnel money into a 529, they should make sure that they’re also setting aside money for their retirement. Teens can always get scholarships or borrow money for college, but you can’t get scholarships for retirement, and relying on your kids for living expenses isn’t most people’s ideal retirement plan.

Since 529 plans only allow penalty-free distributions for college, some parents choose to set aside money in a Roth IRA instead. This gives them greater flexibility to use the money for retirement or college, because you can withdraw contributions (not earnings) tax-free from a Roth IRA to pay for college. However, IRAs carry annual contribution limits of $5,500 ($6,500 if you’re over age 50), and they’re subject to income limits (unlike 529s), so this strategy won’t work for every family.

Whether you’re saving for retirement or college, it almost always makes sense to use tax-advantaged savings accounts. Understanding how 529s work can help give you a leg up on college savings.