Read This Before Opening a 529 College Savings Plan

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If you want to invest for long-term financial goals, then setting up a brokerage account is a great way to get started. But there are also some special tax-favored accounts that are specifically designed to help people save for college. These college savings plans, called 529 plans because of the section of the Internal Revenue Code that created them, allow you to invest money tax-free -- and withdraw funds without paying income tax, so long as they go toward qualified education expenses.

Before you jump into a 529 plan, though, it's important to know all the features that make these college savings accounts special. Just as choosing the right broker is a vital step in any savings plan, picking the best 529 plan can give you big advantages over choosing an ordinary college savings plan. Below you'll learn the most important things you need to know about 529 college savings plans.

You should use 529 money only for eligible educational expenses

Most of the time, investors have to pay taxes on the income and gains on their investments. But 529 plans let you save and invest on a tax-free basis. There’s a catch, though: The government wants you to use the money in a 529 plan only for eligible educational expenses. These include tuition and required fees for students, as well as room and board if the student is enrolled at least half-time in a college program. Typically, you can also use 529 plan money to pay for supplies for classes, including calculators and software products that are required for your course of study.

In the tax reform package that passed at the end of 2017, 529 plans were expanded to allow for spending on educational expenses for K-12 schooling. Now you can withdraw up to $10,000 per year to go toward those elementary or secondary school tuition expenses.

If you take money out of a college savings plan that doesn't qualify, you'll owe tax on the income withdrawn, as well as a 10% penalty. That's designed to keep you from misusing the 529 plan, and it's enough of a disincentive to lead most parents to follow the rules.

Not all 529 plans are the same

There are dozens of different 529 college savings plans available. Most of them are offered directly through state government entities because of the specific wording of the federal law that allows 529 plans to exist, and every state except Wyoming has its own 529 plan. There are also some plans that aren't affiliated with a particular state.

529 plans have limited menus of investment options that you can choose from, usually consisting of mutual funds. Some plans leave it up to the investor to decide how to allocate money, while others use funds that automatically adjust the portfolio's asset allocation according to the student's age and how much time is left before the student begins college. For example, an age-based investment option might be invested mostly in aggressive investments like stocks while beneficiaries are at least 10 years away from starting college, but then gradually shift toward less volatile investments like bonds as students enter their teens.

There are also big differences in the fees that various 529 plans charge. Some states are well-known for their low-cost investment options, while other states' plans charge you relatively high fees for providing the investment funds, leaving less money in your college savings. In general, there's little reason to go with a high-cost 529 plan, and the lower the fees, the more your account will grow and help you cover college costs.

You don't have to use your state's 529, but doing so may be worth your while

Some people think that because their home state offers a 529 college savings plan, they're required to use it. That's not the case, and most 529 plans allow residents of any state to invest in their plans.

However, some 529 plans offer incentives to in-state residents. For example, states commonly offer a state income tax deduction for residents' contributions to their state 529 plans (though there are caps on those deductions). Those deductions typically aren't available if you contribute to another state's college savings plan. If your state offers such a tax break, you should compare how much you'll save on your taxes with how much more your home state's 529 plan charges in fees than the lowest-cost options available nationwide. If the tax benefits are greater, then sticking with your home-state 529 plan will be worth it.

Contribution limits on 529 plans are high, but there are gift tax considerations

Those who are familiar with tax-favored retirement accounts, such as IRAs and 401(k) plans, know that these accounts have fixed contribution limits. With 529 plans, each plan sets its own lifetime contribution limit, but they tend to be high -- $200,000 or more in most states.

However, there are some other limits to pay attention to. If you make a contribution to a 529 plan, then you're treated as making an immediate gift to the student you name as beneficiary of the account. That's not a problem if the amount you contribute is less than the annual gift tax exclusion amount, which is $15,000 for 2019. However, larger gifts require you to file gift tax returns -- and even though you likely won't actually owe tax because of the unified lifetime gift and estate tax credit, it's nevertheless a consideration you should take into account when deciding when and how much to contribute to a 529 college savings account.

Be smart about your college savings plan

If you want to save for college, then opening a 529 college savings plan account makes a lot of sense. By keeping in mind all the details discussed above, you'll be able to identify the best 529 plan accounts out there and open one that will meet your needs while minimizing the expenses you'll have to pay in order to get the tax benefits of the plan.

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