College Savings Plans: What You Need to Know
Whether you’re saving for your child to go to college or planning the next chapter of your career, you have several options to choose from when it comes to paying for school. The good news is that you’re thinking about your options ahead of time, which should help you make the most of your money as you prepare to further your education. 529 plans can be confusing but learning about these programs will help you save money over time as you finance your education, regardless of where you decide to go to school.
What Are 529 Plans?
As the cost of tuition continues to rise year after year, many parents and prospective students have started investing their money in what is known as a 529 plan, or college savings plan. While plan benefits vary by state, (In Colorado you can deduct contributions from your state income tax) your contributions to these programs appreciate tax-free. You also won’t be penalized when withdrawing your money as long as it’s for qualified school-related purposes.
529 plans were designed to help individuals and families finance their education. They were created in 1996 as the cost of college continued to rise. Every state has its own version of the 529 plan, with some offering more than one option.
If you are a prospective student or a parent who knows you want to send your child to college, you can take advantage of these programs to either save money by investing your earnings tax-free or by paying for tuition ahead of time, thus locking in a lower tuition rate.
There are generally two types of 529 plans, including:
College Savings Plans
A college savings plan is like saving for retirement. As you generate income, you have the option of investing a certain percentage of your earnings in your college savings plan, just like you would with a 401(k). These contributions will then rise and fall according to the performance of your investment. Your contributions grow tax-deferred, meaning you won’t have to pay taxes on the gains year over year. You also won’t be taxed once you withdraw the money as long as the money goes toward a qualifying education expense.
You will need to research your state’s specific college savings plan to learn more about the specific terms and conditions.
Pre-Paid Tuition Plans
Instead of investing your money and risking a potential loss, you can use a pre-paid tuition program to pay for in-state tuition ahead of time, thus locking in a lower rate. Again, your earnings will not incur federal taxes as long as your payments go towards tuition. Educational institutions can offer pre-paid tuition programs, but not 529 college savings plans.
In most cases, these payments can be converted to private and out-of-state institutions if the student chooses to attend a different school. You can also take advantage of a Private College Savings Plan, which includes more than 250 institutions if a private school is preferred.
Who Is Eligible?
Anyone can take part in these programs, regardless of their background, location, or income level. The programs available to you may depend on where you live and where you’d like to go to school. However, you’re also free to contribute to out-of-state programs, even if you or your child decides not to go there.
For example, if you live in Arizona and dream of going to school in Florida, you can contribute to that state’s 529 college plan, even if you change your mind and end up going to school in Texas.
What Is a “Qualifying Expense”?
It’s important to understand the terms before enrolling in one or more of these programs. In order to take advantage of the included tax and financing benefits, you will need to put your contributions toward “qualifying expenses.”
This includes more than just tuition. You can also use your earnings for textbooks, academic equipment, supplies, enrollment, computers, application fees, and room and board, with some exceptions. Some states and schools may set limits on housing expenses. You can also put this money toward your private and federal student loan payments.
Some 529 college savings plans and pre-paid tuition programs may not cover expenses that are considered essential, including transportation, health insurance, and food, unless the qualifying school includes these options as part of enrollment.
If you use this money on non-qualify expenses, the usual federal income taxes will apply, as well as a 10% tax penalty.
How Much Can You Contribute?
There are no set limits on how much you can contribute to a 529 plan annually, but it’s important to remember that 529 contributions are considered gifts for tax purposes. This means that they are subject to gift taxes if more than $15,000 is contributed per individual contributor. If a person wanted to contribute more than $15,000 per year, they could use the five-year election to contribute up to $75,000 per year. However, this would limit their ability to make “gifts” and additional contributions in the subsequent five years.
How Much Can You Take Out?
You can withdraw funds as needed to cover your qualifying education expenses. College savings plans can also be used for more than just college. Up to $10,000 per year can be used for tuition at any public, private or religious primary or secondary school.
What Are the Benefits?
In addition to not having to pay federal income taxes on your contributions to these programs, there are many reasons to participate in these programs.
529 plans may not be included as assets on the Free Application for Federal Student Aid (FAFSA®) if owned by the grandparent of the student, which helps students qualify for financial aid. Any student or parental owned 529 assets greater than the asset protection allowance may reduce aid by 5.64%. Additionally, you can change the beneficiary on 529 plans, allowing you to use assets for siblings or other qualifying family members if the original beneficiary doesn't go to college, use all the funds, or gets a scholarship.
Some states offer tax breaks, or partial tax breaks, in addition to those offered on the federal level, helping you stretch your earnings that much further.
Using these programs also makes it easier to report your taxes. You don’t have to report your contributions to these programs on your federal taxes.
You can also change your investment options twice a year at no extra charge as your needs change and your investments rise and fall.
Anyone can take advantage of these programs, regardless of their age or income. A family member can easily contribute to this account as well. However, these plans come with lifetime contribution caps, which usually range from $235,000 - $520,000.
It’s important to note that you, as the owner, will always stay in control of the account. College savings plans do not automatically roll over to your child once they reach a certain age. This is your money and you can spend it as you please. Just remember that you may incur a penalty if you spend your money on non-qualifying expenses.
529 college savings plans are available to encourage Americans to save for college by exempting their earnings from federal, and in some cases, state taxes. These plans are not right for everyone, but as having a college degree becomes increasingly essential in today’s economy, more people are taking advantage of these programs than ever before.
As you get ready to apply or save for college, keep these options in mind to make the most of your hard-earned money. Going to college shouldn’t be any more expensive than it already is.
*This article is intended for educational purposes only and should not be considered financial advice. Consult a tax or financial professional to determine if the information presented in this article is suitable for your personal circumstance.