With college costs continuing to bust families' budgets, many students have no choice but to rack up loads of debt on the road to a degree. While a large number of Americans are recognizing that saving for college should rank up there with other important goals like retirement, many are failing to capitalize on the one tool that could make it easier: a 529 plan.
An estimated 61% of U.S. adults don't have a 529 plan, nor do they plan to start one, according to a recent survey by TD Ameritrade. But if you have a college hopeful living under your roof, that's a mistake you may regret.
The benefit of 529 plans
There are two booming advantages to socking away college funds in a 529 plan. First, you get the option to invest that cash for added growth, as opposed to leaving it in a savings account paying minimal interest.
Imagine you're able to set aside $250 a month for college over a 15-year period. If you were to leave that money in a standard savings account paying 1% interest during that time, you'd wind up with about $48,300. But if you were to invest that money in a 529 plan, you might easily see a 7% average annual return over that 15-year window, which would leave you with roughly $75,400 instead. That's clearly a huge gap -- one that could spell the difference between your child having to take out student loans or not.
Of course, you do have the option to invest your college savings in a traditional brokerage account and snag higher returns that way. But in that case, you'll be liable for taxes on your investment gains year after year, which will eat away at your returns. And that leads to the second major benefit of saving in a 529 plan -- any growth you achieve on your money is tax-free, provided you use those funds for qualified educational purposes.
Furthermore, while you won't get a federal tax break on the money you put into a 529 plan, some states offer their own tax incentives for funding one. And that, too, could make it just a bit easier to sock away funds for college.
Is a 529 plan right for you?
Let's be clear: 529 plans have their drawbacks. The primary one is that if you end up with more money than you need in your account and you withdraw funds for non-education purposes, you'll risk a 10% penalty on that sum. That penalty, however, only applies to the gains portion of your account; it doesn't apply to the principal sum you contribute, since there's no federal tax break for putting that money into a 529 in the first place.
Another thing you should know about 529s is that they're fairly flexible. If you set up an account in one child's name and he or she lands a scholarship that covers the cost of college entirely, you can designate another child or family member as that 529's beneficiary to avoid the just-discussed penalty.
College can be a prohibitively expensive prospect these days, so if you're hoping to help pay for it, be sure to save efficiently. While a 529 isn't your only choice for socking away funds for college, it's one worth considering as you map out your personal savings plan.