Saving for college is no easy prospect, especially when tuition keeps rising. But if you're going to make the effort, you might as well save efficiently, and a 529 plan can help you do just that. But many people don't understand how these plans work, and as such, opt out of them. In fact, 61% of parents don't have a 529 college savings plan and also don't intend to start one, according to a recent TD Ameritrade survey.
If you're in the dark about 529s, it pays to read up on how they work. Here are a few important things you should know.
1. 529 plan withdrawals are tax-free
Though you don't get a tax break on the money you put into a 529 plan, you are allowed to invest your savings for tax-free growth, and you won't pay taxes on withdrawals provided they're used for qualified education purposes. In the aforementioned survey, however, only 32% of respondents knew that withdrawals from 529 could be taken tax-free.
If you're familiar with popular retirement savings plans like Roth IRAs and 401(k)s, you may be used to this setup. With these accounts, you also don't get an instant tax break for funding an account, but your money can then be invested for tax-free growth and withdrawn tax-free in retirement.
Another cool thing about 529s? Some states offer local tax incentives for contributing to one, so while you won't get a federal tax break out of the deal, a state tax break could be on the table.
2. 529 plans cover textbooks and supplies
Many people are quick to assume that 529s can only be used to cover tuition. But actually, you can use that money to cover necessary expenses like textbooks and certain school supplies, like laboratory equipment or even a laptop (provided a computer is required for enrollment, which is the case at many colleges today). As such, you have more flexibility with the funds in your account. In the aforementioned survey, however, less than half of respondents who have or are considering opening 529s knew these plans could cover education-related supplies, so it pays to research the various items you can use a 529 to pay for.
3. 529 plans can be used to pay for housing
Because housing is an optional expense related to pursuing a degree, many people assume a 529 plan won't pay for it. But that's not necessarily the case, because 529s can be used to pay for on-campus housing -- something only about half of people who have or are considering 529s know. But while you may be eligible to pay for a dorm with funds from a 529, you often can't use a 529 to cover the cost of off-campus housing, so keep that in mind as you weigh your options.
Is a 529 plan right for you?
Though a 529 plan isn't your only choice when it comes to saving for college, it's a smart one to consider. The major drawback associated with 529s is that funds withdrawn for noneducational purposes are subject to a 10% penalty, but that applies to the gains portion of your account only, and not the principal amount you contribute. This means that if you put $5,000 a year into a 529 plan over 10 years for a total of $50,000 in contributions, and that sum grows to $70,000 thanks to your investments, that original $50,000 is exempt from any penalties that may apply.
Also, 529s give you the option to change beneficiaries so that if you do wind up with an excess amount of money in your plan (which would be a good problem to have, technically), you can allocate it to another child or family member. As such, it pays to think about whether a 529 plan is the right place to house your college savings, or at least get educated on how these plans work so you can make an informed decision.