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There are smart ways to save for college that come with tax breaks.
The average tuition costs for the 2020 – 2021 school year for a private institution is $37,650, according to College Data. For public institutions for state residents, it was $10,560, while the price tag for out-of-state residents was $27,020.
A 529 plan is an investment account that can help save for college, but there are some notable drawbacks. It can help you plan for future educational expenses, but there are taxes and penalties if you don’t use it for educational purposes.
Read on to learn more about a 529 and whether you should invest in one.
What is a 529 plan?
For the most part, a 529 plan is sponsored by states, government agencies, or educational institutions. When you open a 529 plan for a beneficiary, there are usually a handful of investment options to choose from, such as mutual funds and ETFs.
You can open and invest in a 529 plan for any state, not just the state you live in. So you will do some comparative shopping and see which 529 plan is the best or your needs, situation and benefits that appeal to you the most.
“Most of these 529 plans offer something called a target date fund that makes it easy for the customer,” said Jovan Johnson, a CPA and founder of Piece of wealth planning, a virtual planning agency. “It is an investment option that adjusts based on the risk of the timeline. So it starts off heavier in stocks. And as they get closer to studying, that risk decreases over time.”
A target date fund helps take the guesswork out of your retirement planning by adjusting your risk level according to your age. The younger you are, the riskier your investments, and the older you are, the less risky they become. With regard to a 529, the target date fund will be more conservative as your child approaches college age.
An attractive feature of 529 plans is that they offer some tax benefits. 529s grow tax-deferred, meaning the investments grow tax-free until the investor withdraws them, but only if they are used for qualified expenses such as tuition, room and board. “It comes out with no taxes and no penalty,” Johnson says.
Most states have at least one 529 subscription, and you don’t need to open a subscription in your own state. However, if you are a resident of your state’s 529 plan, you may be able to take advantage of state-level tax benefits. If you sign up for a 529 plan administered in another state, you will not be able to enjoy state tax benefits.
529 plans have a custodian, the person who opened the account, and a payee. A beneficiary can be a child or other relative, friend or even yourself. There are no limits to the number of 529 accounts you can open. Someone can also be the beneficiary of more than one account.
529 prepaid plans
Unlike a 529 college savings plan, which offers a lot of flexibility, a 529 prepaid plan is usually tied to a particular state, public college, university, or institution. As the name implies, it works that you prepay for a number of credits for this particular institution.
“The prepaid plan isn’t as popular because it’s not as flexible,” Johnson says. “Usually, when you sign up for the prepaid plan, you must be a resident of that state and can only use it for a public institution in the state.”
Typically, 529 prepaid plans don’t allow you to use that money for room and board.
How a 529 . to open
Opening a 529 is a two-step process.
“It’s almost like opening an online brokerage account,” says Jackie Cummings Koski, a certified personal finance educator. “You can go to the state’s 529 plan website, and it will ask you for your name, your address, your phone number, and you would name the beneficiary, which is usually the person you are open to. for.”
After you set up the account, choose your investments. “It’s no harder than your 401(k) at work,” says Koski. “Once the account is set up, you will be presented with a menu of investments very similar to what you would get in your 401(k).”
Some state plans give you the choice of working with a fund manager, Koski says. This comes with an additional cost. A nice little bonus is that some states are running a promotion where they’ll give you $50 or $100 to open a 529 subscription, Koski explains. It is usually on May 29 of every year, which is considered 529 Day.
Disadvantages and alternatives to a 529 plan
In some states, there are minimum contribution requirements to open a 529 subscription. In Arkansas, for example, an initial contribution of $500 is required. And in most states there is a monthly requirement, sometimes $10 or $50.
If you make a withdrawal to cover expenses unrelated to education, the IRS counts that as income and you must pay federal taxes on it. In addition, there is a 10% surcharge.
If you opt against a 529 plan, there are other ways to pay for college. These include savings accounts, Roth IRAs, and brokerage accounts just to name a few. If you opt for a savings account, a high-yield savings account can be a good option. This gives you the flexibility to use the money for other things if your child decides not to go to college.
A Roth IRA is another option. Roth IRAs are retirement accounts that allow you to invest after tax dollars. While you can’t take your winnings without penalty until you are 59, but a Roth IRA does allow college education as a qualifying reason to withdraw investments without penalty. A brokerage account allows you to deposit and withdraw money, but remember that you have to pay capital gains on the growth.
What happens if you don’t use it?
If you don’t use the money in a 529 account or end up using it for qualified educational expenses, it could potentially become a major headache, explains Johnson. That’s because you’re talking about potential taxes and penalties. If you don’t use all of the money in a 529 plan, you’ll be subject to a 10% withdrawal penalty and will be subject to income tax on it.
The good news is that there are quite a few ways to work around it, Koski adds. First, you can transfer the money to an account for another beneficiary. You can transfer money as long as it is a qualified family member. The IRS allows you to do this once every 12 months without incurring the 10% penalty. However, you must pay income tax.
Due to the SECURE Act in 2019, funds from a 529 account can be used to pay up to $10,000 of a beneficiary’s student loan or their sibling’s student loan debt.
And if your child receives a grant, you can withdraw money from your account in the amount of the grant without paying a penalty or fee.
Before you decide to withdraw money, it’s important to review the full list of qualifying expenses to make sure you don’t miss out, Koski says. For example, your child’s internet while in school and the computer can be for qualified expenses.
Can you use it for more than one child?
Yes. There are no limits to the number of 529 subscriptions you can open. Plus, the beneficiary doesn’t have to be just your child, Koski Cummings says. “You can open a 529 for your niece, your cousin, your grandchild, your brother, your younger sibling, and so on,” she says. As mentioned, you can even use it for yourself.
“My general opinion is that 529 plans are great vehicles,” says Koski. “You have people who are doing great with the 401(k) or IRA, and they’re looking for the next type of account that they can actually get some sort of tax break out of.
“Traditionally, people think a 529 is for their kids, but it’s not just for kids,” continues Koski. “It could also be an adult going back to school.”
Here are 529’s in each state: