With college costs continuing to climb, many parents find themselves scrambling to cover those tuition bills -- and many teens find themselves signing up for thousands of dollars in student loans. Now the good news, according to a U-Nest study, is that plenty of parents are taking the problem seriously, with roughly 60% setting aside funds for their kids' education. On the other hand, among parents who are saving, the majority are doing so in a checking or savings account, and only 18% are utilizing one of the most effective savings tools available: a 529 plan.
If your goal is to pay for a chunk of your children's education, and minimize the extent to which they graduate saddled with debt, then it pays to consider housing your savings in a 529 plan. Otherwise, you might end up selling your kids short.
The benefits of 529 plans
A 529 plan is a tax-advantaged savings plan designed to cover educational costs. (Note: It used to be that 529s were used solely for higher education, but these days, you can use one for private grade school, too.) The primary benefit of saving in a 529 plan is that you get a chance to not only invest your money, but enjoy tax-free growth on the money your investments make.
When you invest in a traditional brokerage account, and your investments earn money, you're required to pay capital gains taxes on them year after year. Similarly, when you earn interest in a savings account, the IRS gets a cut of that as well. With a 529 plan, you don't pay taxes on your account's gains, which means you not only keep more money, but also get to reinvest your gains year after year for additional growth.
Furthermore, with a 529 plan, you're likely to score a much higher return on investment than what you'll earn in interest from a savings account. And while not all states offer tax incentives for contributing to a 529, there are some that do offer tax deductions or even credits for funding one.
Now like most financial products, 529 plans aren't perfect. First, you should know that if you use the money in your 529 for non-educational purposes, you'll face a 10% penalty as a result. That penalty, however, applies only to the earnings portion of your account, and not the principal contributions you make. Furthermore, some 529 plans do charge high fees and only offer a limited range of investment choices.
Still, it pays to open a 529 if you're serious about covering a large chunk of your kids' education. And if you overfund one child's 529 (say, that child gets a scholarship that reduces his or her tuition costs substantially), you can always designate a new beneficiary, like another child.
Another option? Contribute some money to a 529, but keep the rest of your college savings elsewhere, whether it's a savings account or a regular brokerage account. This way, you'll have more flexibility with some of your money, but you'll also get some tax-advantaged growth on your college fund.
If you're saving for your children's education, you're doing a smart thing, and you can take things one step further by saving as efficiently as possible. It pays to look into opening a 529 plan if you don't have one already. Your kids will thank you for it later.