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529 Plans: The Basics

If you’d like to save for your child’s future higher education expenses while also reducing your tax liability, consider opening a 529 plan. They come in two basic varieties: the college savings plan and the prepaid tuition program. Both are easy to set up and offer the same tax advantages.

College Savings Plan

Every state has at least one 529 savings plan available. You may use whichever state’s plan you like, and can use the money you save and invest at any accredited college or university in the United States.

Each state’s college savings program offers several different investment choices, so shop around for the plan that best meets your financial and educational needs. For example, some begin with aggressive investments and gradually become more conservative. Others offer a “guaranteed option” which protects your principal, but also provides for some investment growth.

Prepaid Tuition Plan

Prepaid tuition plans allow you to buy all or part of a public in-state education at today’s prices. The value of the investment is guaranteed to at least meet college tuition inflation. This can give you a lot of peace of mind. The plans offer a better rate of return than savings accounts and certificates of deposit, involve no risk to principal, and often are guaranteed or backed by the state.

Pre-paid tuition plans are offered by individual states (although not every state has one). The tuition guarantee is based on an enrollment-weighted average of that state’s public college tuition rates. Therefore, if your child does go to an in-state public college, the plan will cover his tuition and fees. However, if he attends a private or another state’s public college, the plan will pay the average of the in-state public college tuition. In other words, you won’t lose the money, but there may not be enough to cover the new institution’s cost. In that case, you’ll have to come up with the difference.

Tax Advantages – and Drawbacks

With both college savings and prepaid tuition plans, as long as you use the investment for qualified education expenses, you won’t have to pay income tax on the earnings. For the savings plans, qualified expenses include tuition, books, supplies, and room and board if the student is enrolled at least half time. In contrast, the prepaid programs typically just cover tuition and room and board. If you use your own state’s plan you may also qualify for a state tax deduction. Your contributions, however, are not deductible on your federal tax return.

If you take any money out for non-educational purposes, the earnings portion of the "non-qualified" withdrawal will be subject to income tax, and you’ll have to pay a 10 percent penalty tax. Some states even add an additional 10 percent penalty for early withdrawal.

Who Can Use 529 Plans

Everyone is eligible to take advantage of a 529 plan. There are no income limitations or age restrictions. While most people use these plans to save for their children, you may use them for anyone, including yourself.

529 Plan Management

One of the advantages of a 529 plan is that you don’t have to do much to manage the account. Either the state treasurer's office or an investment company that is hired as the program manager does that for you. All these professionals come with a price though: management and fund fees can be high, and in some cases even outweigh the plan’s benefits. Also, several plans charge one-time enrollment fees, which range from $10 to $90.

How to open a 529 plan

To know what each state is offering and to compare and contrast plans, visit www.collegesavings.org or www.savingforcollege.com. Many financial institutions offer information about 529 plans, and the option to enroll in the plan with them as well.

After you decide which 529 plan to use, you just need to complete a simple form and make your first contribution – which can be as low as $25. Be sure to sign up for automatic deposits to make savings easy.

Saving for college with tax-advantaged investment vehicles makes good financial sense. Higher education can be a major expense, and saving and investing early will help you achieve this goal efficiently.

For more articles like this one from our partners at BALANCE click here.

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