If you’re a parent who wants to help your child or children pay for college, you probably want to maximize how much you can potentially save and contribute toward their tuition and expenses.
One way to do it is with a 529 savings plan, which is one of the most popular ways for families to maximize their college savings.
As a college financial planner, I specialize in helping families use 529 plans and other financial strategies to help them save for college, and these plans are a great way to help many parents make their children’s college dreams come true .
In this article, we’ll take a look at 529 plans, what they are, how they work, and why they’re such a great option that virtually every family should consider.
What is a 529 College Savings Plan?
A 529 plan is an investment account with significant tax benefits that can help you grow the money you save for college. It can be used for any beneficiary such as your child or grandchild.
One way to think about 529 savings plans is that they’re like a retirement account, but instead of saving for your retirement, you’re saving for your kids’ or grandkids’ college education.
You invest an initial amount, which can be a one-time lump sum. Then you can make monthly contributions. The money you invest potentially grows, just like an investment in a retirement account, but the big advantage is that all your money grows tax-free. As long as you use your 529 plan money to pay for college or for other qualifying expenses, you never have to pay taxes on the growth of the money you invested.
Depending on your state, you may get both federal and state tax benefits from using a 529 plan, so the tax benefits are the big reason why so many parents choose a 529 savings plan to help them plan and save for college.
Some other investments with similar tax benefits are health savings accounts (HSAs) and Roth IRAs. However, a 529 plan allows you to invest a lot more money in your college savings account and grow it tax-free than you can with an HSA or Roth IRA. Those other options have much lower contribution limits, and they’re more suited for saving for retirement (Roth IRAs) and paying for healthcare expenses (HSAs).
Additionally, depending on your state, you can use a 529 plan to pay for college expenses, K-12 tuition, and even student loan repayments. This gives you additional flexibility in how you eventually use the money you’ve saved and invested.
How 529 Plans Work
To set up a 529 plan, you can work directly through your state’s 529 plan website or work with a licensed financial professional. Each plan offers investments in mutual funds, certificates of deposit (CDs), and other investments.
Your 529 plan investments work much like many retirement plans do. As your 529 funds and securities grow, so does your investment, so you can potentially grow your money and earn a nice return that will provide more money to help you pay for college.
Your investment in a 529 plan grows on a tax-deferred basis, and withdrawals are tax-free as long as you use the money to pay for qualified higher education expenses. However, one thing to remember is that a 529 savings plan is an investment. Just like any other investment, it involves risk. When you contribute to a 529 plan and your money is placed in investment funds, and depending on the funds and types of investments, there may be varying degrees of risk. This means you need to be prepared to bear loss, including total loss of principal.
However, with 529 plans, you get to choose how you invest the money. For example, much like a 401K plan, you get an investment selection list of choices, and you get to pick from the list. If you want to be more aggressive and put some of your money in stocks, bonds and more aggressive growth funds, you can do that. If you want to be more conservative and play it safer with CDs, guaranteed accounts, and similar options, you can do that instead. If you don’t like the options available on your list, you can shop around for a 529 plan with better options.
Also, most 529 plans have age-based investment options where your money is invested more aggressively when your children are quite young and more conservatively as they get closer to college age.
For example, as they get older, your money will be invested in safer and lower-risk fixed income and equity investments. This is great for parents who don’t want to worry about making investment decisions along the way and just want to invest their money and let their plan and investment advisor do the rest.
Qualified Educational Expenses
To get the big benefits of tax-free withdrawals on your 529 savings plan, you must spend the money you withdraw on qualified educational expenses. Expenses are categorized into three types: college expenses, K-12 tuition costs, and paying back student loans. Each of these categories has its own rules and limitations, and here’s a quick overview.
College expenses include tuition, room and board, books, computers, lab fees, and similar costs related to the cost of attendance at a college or university. If your student is renting on their own and you’re giving them money for food, these count as qualified expenses as well. Utilities such as Internet access, water, heat and others also typically qualify. But you need to keep good records and receipts of everything in order to report these expenses.
You cannot withdraw money from your 529 plan and use it on travel, or paying off a car, or any other non-qualifying expenses without having to pay taxes on those withdrawals.
K-12 expenses have been added as qualified 529 plan expenditures in some states, and these expenses include grade school and high school tuition. If you’re in a state that allows you to use your 529 plan for K-12 expenses, then you can withdraw up to $10,000 per year for high school tuition and up to $4,000 per year for K-12 tuition without paying taxes.
Room and board or other expenses do not qualify as K-12 expenses. Also, different states have different tax rules, so it’s important to know what’s considered qualified and tax-free for withdrawals in your state or the state where you’re investing in a 529 plan.
Student loan expenses now qualify as education expenses with some states’ 529 plans. In these cases, you can withdraw up to $10,000 per beneficiary to help pay back student loans. But this is a relatively new development, and many states are still deciding whether they’re going to support it. For example, some states tax your withdrawals if you use them to pay back student loans, even if you don’t have to pay federal taxes on those same withdrawals. However, the expansion of qualified educational expenses into K-12 and student loan paybacks opens up new options and flexibility for parents, and even if you have to pay taxes on your withdrawals, using some of your funds to help pay off student loans could be a smart choice depending on your situation and the relative costs.
The Importance of Tracking Your 529 Plan Withdrawals and Spending
To maximize your potential tax benefits, you should keep track of all your 529 plan investments, expenditures and paperwork, so you can make sure you’re able to report everything as part of your tax filings.
Once you’re actually withdrawing and using funds to pay for college, you’ll need to track all of your qualified expenses. You’ll want to document anything that constitutes a qualified education expense and track how much money you’ve actually spent on it. This is important because, if you withdraw more than you actually spend on qualified expenses, you will have to pay taxes on those overdraws.
Colleges will also send you a 1098-T tax form, to document how much you’ve spent on tuition. Your 529 plan will also send you a 1099-Q, which shows how much you’ve withdrawn from your 529 plan for the year. Your tax preparer can use these to help make sure you’re not overdrawing or to determine how much in taxes you’ll need to pay if you have overdrawn or spent some of the money on non-qualifying expenses.
Important Advice About 529 Plans
Before you invest in any state’s 529 plan, you should carefully consider your investment objectives and any risks, charges and expenses. This information is contained in fund prospectuses, summary prospectuses, and 529 Product Program Descriptions and other documents, which are available from a financial professional or directly from a 529 plan’s website.
Read this information carefully before investing. Some 529 plans are better than others because they offer more investment options or lower fees.
Also, it’s important to consider how 529 plans work in your state. For example, do you get a tax deduction for contributing to a 529 plan? If you don’t, then it might be worthwhile to look outside your state to see if there are any plans that offer more investment options and/or lower fees. But if you’re in a state that offers additional tax benefits if you use one of its plans, then you might want to keep your money closer to home.
It’s also a good idea to consult a tax professional, to make sure you understand the state and federal rules around how you make your withdrawals and how you can use your funds on qualified expenses. If you use your money for purposes other than qualified expenses, then your withdrawals can be subject to a 10% federal tax penalty, state penalties, and federal as well as state income tax.
How to Learn More and Get Started with a 529 College Savings Plan
To learn more about 529 plans, plan options in your state, and which options you might want to consider, check out my additional articles about 529 plans here, download my List of Useful 529 Plan Links, and contact me for expert guidance.
As a Certified Financial Planner, I’ve been helping families plan and save for college and invest their money wisely in 529 savings plans for nearly 20 years. And I can quickly answer your questions, point you in the right direction, and even serve as your 529 plan advisor if you’re in one of the states that I serve.
To get started, contact me now.
Registered Representative, Securities offered through Cambridge Investment Research, Inc. a Broker/Dealer, Member FINRA / SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Baldridge College Solutions and Cambridge are not affiliated.
This communication is strictly intended for individuals residing in the states of California, Colorado, Florida, Georgia, Iowa, Illinois, Indiana, Maryland, Minnesota, Missouri, Montana, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Texas, Utah, Virginia, and Wisconsin. No offers may be made or accepted from any resident outside the specific states referenced.
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