The cost of a college education has risen steadily for decades, and parents and students can expect the total cost of tuition, fees, room and board, and other college costs to stretch well into six figures even at some of the less expensive schools out there. To help make saving for college easier, the government created college savings plans, also known as 529 plans, that allow you to set money aside in a tax-advantaged way. Yet many people don't understand the ins and outs of 529 plans and the pros and cons of these tax-favored savings vehicles.
To make sure you know everything you should, below you'll find several important points to keep in mind before you start a 529 plan account. By being aware of the essentials of college savings plans, you'll be more likely to figure out the best way possible to help get your kids through college.
1. 529 plans are tied to states, but you don't have to use the one from your home state.
Each of the 50 states operates a 529 plan of its own, with some additional plans sponsored by educational institutions or other agencies. There's a common misconception that you have to use the 529 plan that your home state offers, but with just a few exceptions, most states allow out-of-state residents to participate in their 529 plans.
Sometimes, as you'll see below, it makes the most sense to use your home 529 plan if it offers additional benefits. But all other things being equal, there's no inherent advantage to using your home state's 529, so don't hesitate to look beyond your state's borders if you can find better plans elsewhere.
2. 529 plans are fairly flexible, but you can only spend 529 money on certain things.
529 plan accounts are designed for educational expenses, and so the tax benefits they offer only apply to certain costs. Tuition and required fees qualify for favorable tax treatment under 529 plans, as do room and board expenses for those students who are enrolled at least half-time. Required books and supplies for classes, such as calculators and software, also meet the requirements for qualifying expenses.
The good news, though, is that 529 plans are fairly flexible. If one child doesn't use all of the assets you've saved, then you can change the beneficiary to another eligible child, often with no penalty or financial consequences of any kind. That can come in handy if your child gets a scholarship or has other financial resources to pay college expenses.
3. Choosing the right 529 plan can save you thousands in fees.
529 plans differ greatly in terms of cost. Because plans have select sets of investment options, once you choose a particular plan, you're stuck with that plan's menu of investments. With some college savings plans, high investment expenses sap your plan account's spending power year in and year out.
A high-fee plan in your state can be a good reason to look outside your state for alternatives. Even in some cases in which you give up extra benefits by not choosing your home 529 plan -- as you'll see below -- the savings in fees and investment costs outweigh those lost benefits. It's important to weigh the pros and cons of each plan before making your choice.
4. Check for extra benefits from certain 529 plans.
Some 529 plans offer added incentives for participating. Many states, for instance, offer state income-tax breaks to those who contribute to their 529 plans, while a few states actually give matching grants to certain qualifying taxpayers who set money aside in college savings plans.
If your state offers an incentive for participating, it's definitely worth an extra look to see if it's worth it. Even with the incentive, though, there's no guarantee that a given plan is the best without comparing those benefits to any added costs or other factors.
5. 529 plans have been under attack by the government.
In this year's initial federal budget proposal from the administration, there were proposals to change 529 plan accounts to remove the tax-free status of withdrawals. For those who saved $5,000 a year in 529 plans earning 6% annually for 18 years, that would have cost families between $22,000 and $31,000 for taxpayers in the tax brackets between 25% and 35%, according to analysis from The New York Times. Although the administration withdrew that proposal, future issues could potentially dilute or remove favorable provisions from 529 plans more generally.
529 plans can be very useful in helping you save for college; but you can't afford not to know the details of using them. Otherwise, you can fall into traps that reduce the effectiveness of college savings plans for your family.