The latest stats tell us that there are now almost 40 million people in the United States with outstanding student loan debt.¹ For parents of young children, that's the sort of future they'd like to prevent, if at all possible.
We all know the cost of college has reached astronomical heights… most young parents shudder to think how high tuition will be once their children hit college age.
529 plans were created with this sentiment in mind. They're a way of saving for college in special tax-advantaged accounts that offer several benefits at the federal and possibly the state level, depending on where you live.
If you have young children (or grandchildren), or if you're planning to build a family soon, you'll want to know about the types of 529 plans and how they can help you manage the cost of saving for your kids' college.
We've put together this easy guide to 529 plans to take the mystery out of it all.
529 Plans, Defined
Imagine a savings account that's invested so that it offers you a possible return every year. Normally those earnings are subject to income tax. With a 529 plan, those earnings are yours, tax-free. The only stipulation is: the savings account is for paying for college for a designated beneficiary such as your child or grandchild.
The idea is to make it easier to save for college (or in some cases, other types of post-secondary training). Typically, 529 plans are started by grandparents or parents, although anyone can set one up as long as they're 18 years old or more.
You may choose anyone you like to be the beneficiary of a 529 plan, even yourself. Can't decide? Setting up several plans is an option, too. Set one up for a friend, yourself, your kids, or even your mom.
There are very few rules for contributing, but be careful on the other end of things, when you withdraw. The funds can only be used for a short list of education-related expenses (see below). Violate these mandates and you're looking at a nice fat tax bill plus maybe even some penalties.
The IRS doesn't like it when taxpayers abuse the "gifts" they've been given!
529 Plans, Explained
The main advantage of 529 plans is that the earnings they produce are not taxed at the federal level. Plus, if your state has an income tax, a 529 plan may offer tax benefits at the state level, too.
There are two types of 529 savings plans:
- Prepaid Tuition 529 Plans. With these, you're essentially locking in the cost of tuition at today's rate. Sounds ideal, but the number of states offering this perk has dwindled to less than a dozen². Plus, the funds from a state-run fund may only be used at in-state public colleges or universities (there may be provisions for converting your fund to one that's eligible for use at private colleges and universities). There may be age and grade limits placed on the beneficiary, too. Finally, most of the state plans that remain require the student or the owner to be a state resident.
- College Savings 529 Plans. Here, the account is established for use at any eligible college or university. These accounts are more flexible. Prepaid plans are just for tuition and mandatory fees only, for example. Savings plans may be used for books, computers, room and board. There are no age limits, whereas the Prepaid plans have age requirements.
Whichever type you choose, setting up a 529 plan is a matter of contacting a financial institution, much like you'd do if you were setting up an Individual Retirement Account (IRA). Each state has a designated financial institution that administers its 529 plans, and you can invest in the plans of any state.
You may also contact your state's education department for resources on getting started.
529 Plans, Applied
When it comes time to finally withdraw and use the fund from a 529 plan, there are a few rules. The 529 plan program was founded in 1996 as a way for parents (or relatives) to help offset the rising cost of college for their children. That means the money is for college, nothing else.
But how do you know which expenses are going to trigger a problem?
Savings may be applied towards tuition and books plus any other education-related expenses you're bound to run into when paying for college. Each plan varies, and you'll have to check with your school for details about your specific plan, but in general these expenses count as "qualified withdrawals" from 529 savings plans:
Qualified Withdrawals
- room & board
- tuition
- mandatory fees
- textbooks
- computers
Keep in mind that textbooks are covered only when they're required for taking classes. As for computers, that's a newer coverage option that started in 2009. Computers, equipment to run them, required educational software, and internet access may now be paid for with 529 funds.
However, gaming equipment won't qualify, with the possible exception of equipment that's required for computer animation or gaming programming courses or the like.
There are some important rules to know about for room and board, too. You may use 529 funds for rent and groceries, but only up to a certain dollar amount.
You may not want to go all-out organic with your groceries because the allowance is only as much as your school has set as reasonable. Every school sets a room and board allowance for federal financial aid reasons. What they determine as reasonable is what's used to define what qualifies for a 529 expense.
So if your plans for college living include a penthouse in the nicest area of town and regular deliveries of fancy European cheeses that cost more than a meal at the Olive Garden, just know that your 529 money will only go so far.
Instead, plan on living the typical life of a student: ramen, annoying roommates, and learning to budget your expenses, knowing that someone who loves you made it all possible by funding a 529 plan for you.
Resources
- Student Loan Debt Statistics. Statisticbrain. Retrieved 6/6/2016
- Do Prepaid 529 Plans Ever Make Sense? U.S. News & World Report. Retrieved 6/6/2016
- 529 Plans: Questions and Answers. Internal Revenue Service. Retrieved 6/6/2016
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Corey Purkat, CFP®, AIF® is the Founder & CEO of Northwoods Fiduciary Advisors, a fee – only RIA that specializes in working with small business 401(k) plans and is located in St. Paul , Minnesota. Corey and I became friends after connecting through the XY Planning Network and I asked him to write some thoughts on 529 Plans as a guest topic for this site. |
Corey Purkat | Northwoods Fiduciary Advisors