Just when you thought college couldn't get more expensive, its costs continue to climb -- so much so that even higher earners struggle to keep up with tuition. Former graduates, meanwhile, owe well over $1 trillion in loans, and future students are likely to add to that total if things continue the way they've been going. If you'd rather your children avoid that fate, then the best thing you can do is start saving for college as early as possible -- before your kids are even born, in fact. The question is: Where should you house your savings?
Of the various choices out there, one you might strongly consider is a 529 plan. Though these plans aren't perfect, here's why you should consider one for your college fund.
1. Tax-free growth on your savings
Although the money you put into a 529 isn't tax-free, once that cash hits your account, it gets to grow tax-free until you're ready to withdraw funds to pay for college. This means that if you contribute $50,000 of your own money, and it grows to $80,000 because of your investments, you won't have to pay taxes on that $30,000 gain -- whereas you would with a traditional brokerage account.
There is, however, a caveat. You must use the money in your 529 to pay for qualified higher education expenses. Otherwise, you could face a 10% penalty for money withdrawn for non-college purposes. Still, that penalty applies just to the earnings portion of your account, not the principal.
2. Higher returns than a savings account
Many families opt to save for college in a traditional savings account -- but if you want to grow your money to make a dent in those tuition bills, you're better off going the 529 route. These days, you'll be lucky to get just above 1% on your money in the bank, whereas with a 529, you might easily score a 7% return on your cash. And, as we just learned, that's money you won't be taxed on year after year.
To illustrate what a difference this might make, imagine you're saving $300 a month for college over a 15-year period. With a savings account paying 1%, your balance will grow to just $58,000. But with a 7% average annual return, you'll be sitting on a little over $90,000, and that could make a huge difference in managing your total education costs.
3. Local incentives
Though 529s aren't funded with tax-free dollars, most states offer financial incentives for contributing to their plans. Of course, you're not required to save in a 529 sponsored by your home state, and doing so isn't always the best idea since you might find another state's plan whose fees and setup work better for you. But there are a few states that offer a tax deduction for contributing to any state's plan, and a few even offer a limited tax credit for contributions. If your state is among the more generous ones when it comes to 529 plans, then it especially pays to look into one if you know college is on the horizon.
Of course, as my colleague and college savings expert Dan Caplinger points out in this article, 529s have some drawbacks. Some plans, for instance, offer limited investment options and high fees. And, if your college costs somehow come in lower than expected, you risk that 10% penalty I talked about earlier. But if you're looking for an efficient way to save for college while reaping some modest tax benefits, you'd be wise to look into a 529, whether one issued by your home state or another state.
Another idea? Contribute some money to a 529, but explore other, less restrictive college savings options as well. This way, if you don't end up needing quite as much money for college as anticipated, you're less likely to end up losing a portion of your assets.