By Kelly Hodges
Now that you’ve calculated how much it will cost to send the apple(s) of your eye to college (and recovered from the minor stroke you had when you did the calculation), it’s time to figure out the best vehicle to use for saving. There are many ways to save for a child’s education; from stashing cash under the cushions to permanent life insurance plans to brokerage accounts and everything in between. However, there have been two savings mechanisms that have emerged as the most popular way to set aside educational funds; the 529 savings plan and the Roth IRA. Here’s a nuts and bolts description of the 529 plan to help you determine if it might make sense for you.
1. The 529 savings plan gets its name from the wildly popular Section 529 of the US tax code.
2. The sole purpose of a 529 plan is college savings. Parents (or grandparents) are the owners of the accounts, and their children (or grandchildren) are beneficiaries. The contributions and earnings within the plan may be used for educational expenses including tuition and fees, room and board, and books and supplies.
3. Each state runs its own 529 plan, so each state’s plan will be different. For example, one state may operate their plan through Vanguard and another through Wells Fargo. The investment choices within each plan are typically fairly limited. You may purchase a plan through any state, but there are usually tax advantages of using your home state’s plan.
4. The funds can be used at any college in any state. It does not matter what state your plan is operated through. You could live in Alaska, have a plan through West Virginia, and your child could go to school in Florida.
5. If your child happens to be a star quarterback and gets a full college scholarship, the 529 plan can be used for graduate school expenses or transferred to another beneficiary (like a sibling) without penalty.
6. The major attraction of the 529 plan is the tax benefits it offers. All contributions made to the plan are in after-tax dollars, and earnings then grow in the plan tax-free. As long as the money is used for qualified educational expenses withdrawals from the plan are tax-free as well. Each state may offer additional incentives in the form of state income tax deductions or credits to entice parents further. For example, Wisconsin offers a $3000 deduction per dependent beneficiary, meaning a parent of 4 would be able to deduct up to $12,000 per year from their state income tax. Deductions and credits vary by state, and obviously don’t apply in states without income tax.
7. If you do not use the funds for educational expenses, you will be subject to penalties such as a 10% penalty on any earnings (not on principal) and you may have to pay back any prior deductions taken on your state taxes in previous years. You will also be subject to paying taxes on the earnings portion, generally at the ordinary income tax rate. For more information, visit the irs.gov site.
529 college saving plans are a good option for many parents seeking to get a start on college savings for their children. The Roth IRA offers another nice alternative, and we’ll discuss some pros and cons of this approach in the next article. Either way, be sure to contact a licensed professional for a more thorough analysis of your personal situation and tax implications.
Recommended Reading: Part 1 of the series, College Savings 101 – Reality Check.
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of her employer or any other person or entity.