Saving for College? See if a 529 Plan Is Right for You

529 plan

Although I had to pay for my own college education, I avoided student loans for the most part by choosing an inexpensive school, working full time, and qualifying for scholarships. But those options might not be enough for my kids to avoid taking out loans when they start college.

After all, the average household student loan debt has increased by 828 percent over the last 18 years, according to Federal Reserve data analyzed by Axios. Who knows where it will be in another 18 years?

That’s why having a 529 plan or another college savings plan is essential for parents who want to help their kids avoid as much student debt as possible. Read on to learn whether a 529 plan is right for you.

What is a 529 plan?

There are two types of 529 plans: the 529 college savings plan and the 529 prepaid tuition plan. Although it’s important to compare the features of both plans, we’ll focus on the more popular 529 college savings plan here.

Most states have a state-sponsored 529 college savings plan that allows you to invest your contributions. The account has one beneficiary, and you can withdraw the earnings tax-free for the beneficiary’s education-related expenses.

Pros of having a 529 college savings plan

Tax advantages

The money you earn in a 529 college savings plan account is free from federal taxes if you use it for qualified education expenses. According to the IRS, eligible expenses include:

  • Tuition and fees
  • Books, supplies, and equipment
  • Room and board

If you use the money for nonqualified expenses, not only will the earnings be taxable, but you’ll also pay a 10 percent penalty. One exception is if your child receives a scholarship, at which point you can withdraw up to the amount of the scholarship penalty-free.

In addition to the federal tax advantages, you also might get incentives from your state. For example, the state of Utah gives me a 5 percent state tax credit on contributions I make to my son’s 529 plan — up to $192 per year.

Not all states offer state tax incentives, though. Check to see if your state does before you apply.

You can shop around

If you don’t like your state’s 529 college savings plan, you’re free to choose one administered by another state. Some states offer lower fees, so you can compare your options to find the best 529 plan for you.

The only caveat is that you can’t get a state tax deduction on another state’s plan if you’re not a resident.

Generous limits

Account limits for 529 college savings plans are set on a state-by-state basis. They’re generally based on the amount necessary to cover qualified education expenses.

For example, the state of Utah estimates the education costs for four years of college and two years of graduate school to be $430,000. This amount is the maximum account balance for one beneficiary, and you can contribute as much as you want up to that amount at any time.

Keep in mind, though, that federal gift tax consequences might apply if you contribute more than $14,000 per year (or $28,000 for married couples).

Cons of having a 529 college savings plan

Limited investment options

Some states offer limited investment fund selection for their 529 plans. If you’re an inexperienced investor, you might not think much about it. But if you’re a savvy investor, you might want more control over where your money gets invested.

If you shop around, you can seek out a state plan that offers more fund options. But there’s no guarantee you’ll get low fees along with it.

Some plans have contribution requirements

If you want to save for college at your own pace, your options might be limited. Most states have a monthly contribution requirement, and some even have a minimum initial deposit.

For example, South Dakota’s 529 college savings plan requires that South Dakota residents open an account with at least a $250 opening deposit ($1,000 for nonresidents). Going forward, you must contribute at least $50 per month.

There’s no guarantee your child will go to college

Let’s say your child decides to skip college. What happens to all that money in your 529 college savings plan?

If you have another child, you can make him or her the beneficiary instead. But if you don’t have other kids or you have sufficient savings for them, any nonqualified withdrawals you make from your 529 plan will be subject to taxes and a 10 percent penalty.

Helpful alternatives to a 529 plan

If you’re not sold on the idea of using a 529 college savings plan, here are a few other options you can consider.

Coverdell Education Savings Account (ESA)

For the most part, a Coverdell ESA functions similarly to a 529 plan. The main difference is that you also can use it to fund K-12 educational costs, including private schools.

If you’re a big saver or have a high income, though, a Coverdell ESA can be limiting. You can contribute only $2,000 per year to an account. Plus, your modified adjusted gross income can’t be higher than $110,000 to establish an account (or $220,000 if you file a joint tax return).

Roth IRA

A Roth IRA sounds like a great place to save for retirement, not college. But depending on your situation, you could do both. That’s because the IRS allows you to withdraw money for college expenses tax-free and penalty-free. The only requirement is that the account is at least five years old.

Roth IRA earnings also grow tax-free, so you’re on par with a 529 plan’s federal tax advantages. There’s no state tax benefit for Roth IRAs, though, so a Roth IRA is a great option if your state doesn’t offer a state tax incentive with its 529 college savings plan.

Plus, if your child doesn’t go to college, you can keep the money for your retirement savings instead.

The main drawback to a Roth IRA is its income and contribution limits. You can contribute up to $5,500 per year, but you can’t contribute at all if your income is above a certain level, depending on your tax filing status.

Taxable investment account

If you want maximum flexibility with your money, consider a taxable investment account. There aren’t any tax incentives, so your return on investment might be a little lower. But you’re not required to use the money you place in it for college expenses.

Should you save with a 529 plan?

When it comes to saving for college, there’s no one-size-fits-all answer. For many parents, 529 plans are a great way to save for education expenses while also enjoying state tax incentives. But others might find 529 plans limiting in terms of what they provide.

For me, flexibility is paramount, so I’m experimenting with a mixture of a 529 plan and a taxable investment account.

Always review several 529 plans and alternatives to determine which choice is best for you. Consider the tax benefits, fees, and flexibility of each option. Then, decide what your top priorities are.

And don’t forget: The sooner you start saving, the better. So don’t delay.

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