Saving for Your Child’s Education: 529 College Savings Plans
Families reported paying $30,017, on average, for higher education in the academic year 2019–20, according to Sallie Mae’s 2020 “How America Pays for College” report conducted by Ipsos. Throughout a student’s (typically) four-year university career, those costs can accumulate dramatically.
Parents who would like their children to attend college should start saving as early as possible. Many parents start saving once the baby arrives or soon before, but adults who know they want to have children can start setting aside money as soon as they make that decision. A 529 college savings plan is one of the easiest and best options for parents to save for college: It’s tax-free and can be used for qualified educational expenses for any of your children — even first cousins.
A 529 is a tax-advantaged college savings plan sponsored by all 50 states and the District of Columbia. It comes in two forms: Prepaid tuition plans and education savings plans. In the academic year 2019-20, 37% of families used a college savings account like a 529, up from 21% in 2018-19, according to Sallie Mae’s 2020 “How America Pays for College” report conducted by Ipsos.
“We encourage folks to inquire about 529s and work with representatives to get them started,” said Amy Nelson, Financial Wellness Coordinator for Nevada Money Mentors at the University of Nevada, Reno. “We see so many students who don’t understand the ways to pay for school to set them up for long-term financial success, and 529s are a great way to kick-start that financial success.”
While 529 plans may not have an age limit, depending on the state, some prepaid tuition plans and Coverdell education savings accounts (ESA) might have an age limit on the beneficiary or penalties for withdrawing early.
The Benefits of College Savings Plans
You might not be able to see the benefits of college savings plans right away, but over time, you can see your investment begin to grow. Take a look at the chart below. You can rollover the bars with your mouse to view the dollar amount for each year.
Let’s say your initial contribution is $1,000 for Year 0, and then every year, you contribute $1,000. There is an 8% interest rate and a 33% tax rate. By Year 2, you might have $2,054 in savings without tax sheltering. Tax shelters are ways to reduce tax liabilities, which include programs like 401(k) plans. With tax sheltering, you could have $2,080. That’s about a $26 difference, on average.
Now, fast-forward to Year 20. You can see a considerable increase: a 36% investment growth with tax sheltering. That's about $50,423, compared to $37,194 without tax sheltering.
What Is a 529 Plan?
College savings 529 plans, known as qualified tuition plans, come in two different forms: Education savings plans and prepaid tuition plans. Education savings plans have the most flexibility as they can be used for qualified higher education expenses for the beneficiary, or beneficiaries, of the account. They are custodial accounts, meaning that the account is in the custodian’s name, typically a parent. They are sponsored by states, state agencies or educational institutions and are authorized by Section 529 of the Internal Revenue Code (IRC).
The individual IRS gifting limit per year for a 529 plan is $15,000. A couple gifting limit per year for a 529 plan is $30,000.
Starting Your Child’s College Savings Plan
Optimally, parents should start researching 529 college savings plans, which are available in most states, except Wyoming, and the District of Columbia, before they have children. Check out the College Savings Plan Network, which was created by the National Association of State Treasurers. It allows shoppers to compare the plans in each state.
Types of 529 Savings Plans
Education savings plans are a way for families to pay for college and reduce a student’s future burden of student loan payments. A fund manager can work with age-based and enrollment-date investment portfolios, and they typically have a more aggressive portfolio at the beginning of a child’s life. They become more conservative as the plans get closer to term, so the earlier parents start a plan, the better. They are tax-free as long as the funds are used for qualified higher education expenses.
Another option is a prepaid tuition plan, which is available in 10 states. Parents can pre-purchase future tuition for their children at a predetermined rate today. The benefit is that you lock in current tuition rates, but the risks are, you have to purchase the tuition at a specific university — so if the student opts not to attend that school, the funds can transfer, but not at the current tuition rates instead of the locked-in rate.
34% of students use parent help for college.
Source: Amy Nelson, Financial Wellness Coordinator for Nevada Money Mentors at the University of Nevada, Reno
Tax Benefits Using a 529 Plan
A 529 is the optimal savings plan for those looking for tax cuts as it is entirely tax-free when used for educational expenses. Anyone can contribute to a 529 as long as they stay within the IRS tax gifting limit of $15,000 per person per year.
The great thing about a 529 plan is that, even if the custodian experienced a financial hardship and had to withdraw funds from the plan, the custodian would only pay tax penalties on the account’s investment gains.
One thing to keep an eye on is the IRS rules for qualified higher education expenses since they’re subject to change every year, said Karen Vibe, an Ameriprise financial adviser. She suggested saving receipts for any items purchased with 529 funds for tuition and fees, books, room and board, transportation and other educational expenses.
There are also tax breaks for married couples filing jointly (household adjusted gross income up to $130,000) and single individuals ($65,000) for tuition and fees. You can find tax guides for students and parents to help you navigate college expenses and tax benefits.
People can fast-forward a gift for five years into a 529 plan. The max a couple could contribute at one time is $150,000 ($30,000 per couple for five years cumulatively).
Source: Karen Vibe, Ameriprise Financial Adviser
Including Additional Children on a 529 Plan
A 529 plan can only have one beneficiary at a time, but you can change the beneficiary. For parents with more than one child — especially if the children are four or more years apart — the question of whether to open one 529 for all the children, or a 529 plan for each individual child. This question can boil down to how much the parents plan to contribute to the plan each year. If they plan to contribute more than $30,000 to the plan each year (or if, for example, grandparents plan to contribute more than the annual gifting max), then opening multiple plans would maximize the tax benefits.
Just remember — You must use the 529 funds for qualified educational expenses, so no stashing away the funds to give to your child as a downpayment on a house or a car when they’re older, unless you want to pay steep tax penalties.
Since you can easily transfer the funds from sibling to sibling, there’s no risk of opening a plan for a child who may not attend college. You can also use the funds from 529 plans up to age 28, so you can use them for graduate school as well.
“Generally, the best idea is that you can transfer the funds within the same generation, so (the money is) very fluid,” Karen Vibe said. “You can flip the money back and forth between siblings and first cousins without any penalties. The last option is to pull the money out and pay penalties on the funds you don’t spend on education. Be very careful with that. I advise people to keep it among the kids and use it for other educational expenses.”
Finding and Choosing the Best 529 College Savings Plans
Each state offers different 529 plans, so make sure to comparison shop the plans available before you make a decision. Look at the performance of the plans and do some research into the plan’s fund manager. You’ll also want to make sure to look at the fund’s residency requirements, state matching grants, associated fees, minimum initial contribution and deferred earnings or withdrawal.
What to Look for in a Savings Plan?
According to the College Savings Plan Network, the plan features include:
- Type (Savings plans vs. prepaid tuition plans): According to the College Savings Plan Network, “You should consider the flexibility of a savings plan account versus the tuition guarantee of a prepaid tuition account. Note that a prepaid account is designed for use at colleges in your state of residence (or the beneficiary's state of residence).”
- State Tax Benefits: Some states offer significant tax advantages such as a state tax deduction and deferral of taxes on earnings, which make the plan more attractive.
- Fees: Check the various commission and broker fees associated with each plan.
- Minimum Initial Contribution: Compare this among different plans to make sure you’re comfortable with the initial contribution requirement for the best 529 plan.
- Minimum Subsequent Contributions: Make sure the plan doesn’t require monthly or annual contributions that exceed your budget.
In the Spotlight: Top College Savings Plans
The best 529 plans are age-based blended plans in states with no state income tax or states with the best state income tax benefits, up to $20,000 for couples and $10,000 for individuals in Oklahoma and Illinois. An important note: Some states don’t offer multiple plans, so you could have only one choice depending on where you live.
Alaska T. Rowe Price College Savings Plan
The Alaska T. Rowe Price College Savings Plan offers static or enrollment-based portfolios that are target-date investments. It’s the only plan in Alaska that isn’t tied to a specific university. Alaskans benefit from no state income tax. Unit prices for plans range from $11.76 for the Portfolio 2039 plan to $36.67 for the Equity Portfolio. Performance returns run from 3.81% for the Portfolio 2039 plan to 11.19% for the Portfolio 2030 plan (since inception). Alaska has no state income tax, so this is a benefit when shopping for a 529 plan.
Florida 529 Savings Plan
The Florida 529 Savings Prepaid Plan offers prepaid tuition or college savings plans for children and parents who have been residents of Florida for the past 12 months. The state of Florida guarantees the funds in the prepaid plan, and both plans allow transfers to eligible students. Money Market Funds offered the lowest annualized investment return at 1.39%, with the Large Cap Growth Equity Fund performing the best at 13.90%. Florida has no state income tax.
Illinois Bright Directions College Savings Program (Direct & Advisor)
The Illinois Bright Directions College Savings Program (Direct & Advisor) offers age-based portfolios, target portfolios, individual fund portfolios and portfolios for registered investment advisors. Year-to-date average annual total returns for age-based portfolios with aggressive, moderate or conservative portfolios were strongest in the aggressive portfolio with an 8.64% lifetime return rate for ages 0-2 and weakest for the age group 19+ at .80%. This plan does have a reward program. Illinois taxpayers can deduct $10,000 per year per individual in a state tax credit.
MOST: Missouri's 529 College Savings Plan
Missouri’s 529 College Savings Plan offers portfolios through Vanguard, Ascensus and Dimensional Fund Advisors (DFA). DFA Plan owners can contribute up to $325,000, which includes all 529 accounts sponsored by the State of Missouri for the same beneficiary. Annualized returns over the plans’ lifetime since inception range from 1.54% for the Vanguard Interest Accumulation Portfolio to 12.22% for the Vanguard Total Stock Market Index Portfolio. Missouri taxpayers can deduct $9,000 per year per individual in a state tax credit.
Oklahoma 529 College Savings Plan
The Oklahoma 529 College Savings Plan offers a guaranteed option, risk-based option and enrollment-year investment option plans. The annualized return rate for the plans since inception runs from 2.54% for the guaranteed option plan to 12.88% for the U.S. equity index option. Unit prices for enrollment-year options range from $10.43 to $11.37; guaranteed option unit value is $16.23; and risk-based options range from $17.48 unit value for a fixed income option to $34.23 for the U.S. equity index option. Oklahoma taxpayers can deduct $10,000 per year per individual in a state tax credit.
Texas College Savings Plan
The Texas College Savings Plan offers age-based portfolios, static portfolios and individual fund portfolios. The average total return across the various portfolios runs from 0.60% for the TCSP U.S. Government Money Market to 6.34% for the TCSP 100% Equity Indexed Plan. The low unit value is $10.51 for the TCSP U.S. Government Money Market, and it goes up to $36.66 for the TCSP 100% Equity Blended fund. Texas has no state income tax.
Washington Dream Ahead College Investment Plan
The Washington Dream Ahead College Investment Plan offers Year of Enrollment portfolios, Static portfolios and Adding to Multiple-Year portfolios (for advanced investors). Investors can get started at $25. Performance ranges from 1.52% for the college enrolled growth portfolio to 18.81% annualized return rate since inception for the static income and growth portfolio. Washington has no state income tax.
Find Your State’s Plans
Make sure to compare the prices and performance of the plans offered in the state you reside in. Plans can vary among states. Here’s a rundown of all the 529 plans available in the United States:
529 Savings Plans Frequently Asked Questions
Starting a savings plan for your child can help to reduce college expenses later down the road. Here are a few frequently asked questions about 529 college savings plans.
Expert Insight on 529 College Saving Plans
What are some common misconceptions about 529 Plans?
“By saving for college, it will hurt my financial aid opportunities.” For most families, this is minimal due to how financial aid is calculated for parent assets. “You must report all 529 savings plan money for all children,” which is true. ... The reporting of 529 plans for the FAFSA and those colleges that use additional financial aid forms could be different.
If a 529 is tied to prepaid tuition, people may be under the impression they can use that at any school or for other expenses, but it’s for tuition only at specific schools. … Prepaid tuition is a little more expensive right off the bat. You pay for the cost of tuition as it’s set now, so you pay at today’s rate and can use those funds at other schools at the current rates. See how far the dollars you invested for a particular plan would get you at another university.
People don’t understand the plans and how they work. You can purchase 529 plans in any state. There certainly are funds that are better than others. Financial advisers can help and can do research on fund managers. Pick highly ranked 529 plans and performances. … It’s important to save as you go for college.
How do taxes work with 529 Plans?
Some states offer contribution incentives that can reduce a family’s state taxable income since 529 plan money grows tax-free. Distributions from a 529 plan are tax-free as long as they are used for qualified college expenses. Under the SECURE Act, up to $10,000 can be withdrawn for qualified expense of private pre-college education expenses. The qualified expense includes tuition, fees, room, board, books and some supplies. This would include off-campus living as long it is under the college allowable off-campus living expense number. Non-qualified withdrawals are taxed as ordinary income, and a 10% penalty is applied.
If you use it for qualified educational expenses (such as room, board, tuition and books), there are no taxes. If you use it outside of that, you have to pay income taxes plus a 10% penalty. Financial aid offices have a cost of attendance, which includes room and board, fees, transportation, etc.
They’re not taxed at all — everything’s deferred. That’s what’s so cool and why a 529 is such a good investment.
What are the biggest advantages to 529 Plans?
It grows federally tax-free and reduces the amount of money that would be borrowed to achieve a college education. It has a minimal impact on the financial aid calculation in comparison to a parent’s income and is a great estate-planning tool for grandparents to minimize their estate. It can be moved from child to child without penalty, and you can avoid the penalties if the child receives scholarships. Withdrawals need only to pay the income tax due. And now, under the SECURE Act, it can be used to pay down student loan debt.
Having the money upfront to pay for your child’s education is amazing. The funds are transferable, so if you have one child who doesn’t want to go to college, you can transfer the funds to a sibling. They gain more interest and exponential growth over the years if you start the plan when your child is young. Also, you get a tax break because you’re not paying for taxes on those funds. Plan ahead. Invest early.
One and done. A lot of people like automatic rebalancing. Keep putting money in (the account), and when your children need it, it’ll be there. People like that type of automatic, self-funded account. Also, anybody can give a gift, which is great. A 529 plan is in the name of the custodian.
How much can you put toward each plan?
Each state has its own limits. Some states offer annual state income contribution limits, and due to some estate planning abuses, contribution limits were set.
Monies are at the gifting limit, which is $15,000 per year or $30,000 per couple. But Grandma and Grandpa or others can give $30,000 per year together. For 529s, if you want to fast-forward a five-year gift into a 529, you can. So you take $30,000 for a couple times five, they could put $150,000 per year in a 529 plan. It’s such a great vehicle for that. From a dollar amount standpoint, that is the way to have your child gather funds for college — it’s a great tool. (It’s) limited in regard to their investments. There’s more scrutiny on how funds are regulated and who can ask them and when. At the beginning of life, investments are more risky and then get less risky as they age. By 18, funds are in stable funds. People love that because there’s nothing that a financial adviser has to manage, so it’s less work for the parents
How has Covid-19 impacted my 529 Plan?
I am unaware of any issue directly impacting the 529 plans. The issue is the impact it will have on college costs. More families are rethinking the college value with now hybrid learning. It is not being discussed, but there could be a tax risk on college refunds if the billing was paid with 529 money, and that was returned. I think that will be small and will be difficult to trace.
FAFSA takes tax returns from the prior year, so they wouldn’t show any sort of layoffs a parent would have experienced in 2020.
Not really, it hasn’t affected 529 plans. For the quarter, it was difficult, but the plans are so regulated that the 529 plan managers have an obligation to rebalance those. If there’s a huge sell-off in stocks, they sell off bonds and buy stocks, which is exactly what they’re designed to do.
What are a few common mistakes made with 529 Plans?
Not confirming the tax benefit that your state could offer, such as other family members who are considering setting up a 529 for a child in another state. You need to evaluate each state’s plan and the ownership aspects before making that decision. Also, make sure you understand the age-based risk issues. If you are in an age-based 529 portfolio, as the child approached college, the overall portfolio moves to a fixed-income investment. We have seen interest rates decline, which has been a benefit to these funds. If, at some point, interest rates start to move up, this could cause the bond funds to lose value, which most people do not understand. Finally, make sure to report 529 assets on the FAFSA and align the proper beneficiary to the withdrawal associated with the college expense.
Understand exactly how they work and understand what the qualified expenses are so you don’t end up paying taxes and penalties.
Not understanding all the rules and advantages. People believe they’re far more limiting than they are, so they need to educate themselves. A 529 is a phenomenal way to save for the future for your kids. If you need to get money out, the penalty is only on the earnings. If you have to take it out, it’s your money, so the only penalty is on the earnings. Great place to go for Plan B or C if parents are desperate for money. One person has to be the custodian. If parents get a divorce, and Mom wanted to pull the money out, then she could, as the custodian, even if Dad’s family had put the money in. Make sure there’s a back-up custodian.
Are there other ways to use a 529 plan, other than for college?
The SECURE Act has approved the use of both elementary and high school educational expenses, which are limited to $10,000 per year. The SECURE Act has also approved the use of student loan repayment, which has a $10,000 limit per year.
You can use them for any type of educational expenses or qualified expenses. If a student decided to go to a technical or beauty school, they should be able to use the money for that as well — registered apprenticeship, technology needs, trade schools, etc. Transportation, travel and similar expenses don’t qualify as qualified expenses, but computers and internet count as eligible educational expenses.
How do 529 Plans work with multiple children? How should parents handle having multiple children on a 529 plan? Is this a good practice?
To save fees, having one account may help with some of the plan fees. Once withdrawals start, you need to set up the beneficiary for each account properly. Any saving for college is a great thing since it will reduce the need to borrow money. In reporting the 529 assets on FAFSA, all immediate 529 plan money must be reported even if the beneficiary is not in college, since they are reported as a parent asset. ... When you have multiple children in college, the parent’s EFC (estimated family contribution) is divided by the number of children in college.
Advisers sometimes recommend having multiple children on one plan, or you can have separate plans for different kids. Work with someone knowledgeable to discuss the long-term plans of a 529.
You can have one plan or separate plans. With 529 plans, students can use the funds up to age 28, so they can be used for graduate degrees as well. Generally, the best idea is to transfer within the same generation, so it’s very fluid. (You) can flip the money back and forth between siblings and first cousins without any penalties. The last option is to pull the money out and pay penalties on the money you don’t spend on education. Be very careful with that. I advise clients to keep it among the kids and use it for other educational expenses.
Can you pull out the money early? If so, how does this work with taxes? And can you only spend on educational expenses?
(You can) pay penalties only on the gains. (For) qualified educational expenses — the IRS changes them every year — the IRS is pretty generous as far as qualifying items. … Keep your receipts and have a good idea of what you’re spending the money on.
Can you lose money? What are the risks?
Yes, you can: These are investments, and the portfolio that is selected will carry the same risk as other investments.
It is tied to investments, so if the stock market goes down, then you could lose money. You can also be penalized if you withdraw early or for non-education expenses.
You don’t get to pick your stocks or manage your investments, and investing is not strategic in any way.
Since 529 plans are types of investment, what are some ways parents can protect their money rather than potentially losing some or all their money?
All of the plans have a variety of investment options, which could be based on investment risk or an age-based system that changes as the child gets closer to college. Some of the state plans offer a tuition-based investment return. These plans are normally more conservative, and the increases are normally based on the tuition increases for that state’s universities. These typically work well in the child stay in state or uses the state’s university system. More plans are offering actual CD options. This would be an easy way to protect a person’s principal investment.
For education, 529 is one of the best ways to save. There are other routes, such as saving accounts, mutual funds, etc., but they won’t give you the tax benefits a 529 would. If your state offers prepaid tuition plans, that would be a good option. They’re not as complicated as you’d think. Students are seven times more likely to go to college if they knew they had money in an account.
It’s an automatic, so parents don’t have to manage it. It is invested in the market and will fluctuate in value, so people have to understand that.
Resources for 529 College Savings Plans
There are many resources available to help parents research 529 plans. You can start your research with the College Savings Plan Network, which allows you to compare plans, then read more about tax compliance, restrictions, financial manager research and an expense analyzer.
College Savings Plan Network: My State’s 529 Plan: The College Savings Plans website allows you to compare multiple plans at once and sort by investment type, plan type, residency, state tax credit or deduction, state tax-deferred earnings or withdrawals, financial aid benefits, state matching grants, reward programs, plan fees, contribution amounts and investment management companies.
U.S. Securities & Exchange Commission’s Investor.gov: This site offers investment product information, fees and financial calculators. You can research investment plan managers and investment professionals, and learn about their background and registration status.
Internal Revenue Service: “Frequently Asked Questions on Gift Taxes”: You can learn about gift tax issues and regulations here, as well as deductions, exclusions and more.
529 Expense Analyzer: The Financial Industry Regulatory Authority (FINRA) developed this tool that lets you compare two plans at a time. You can compare the holding period, investment amount, the annual rate of return, sales charges, other fees and more.