Saving for Your Child’s Education: 529 College Savings Plans

Families reported paying $30,017, on average, for higher education in the academic year 2019–20, according to Sallie Mae’s 2020 “How America Pays for College” report conducted by Ipsos. Throughout a student’s (typically) four-year university career, those costs can accumulate dramatically.

Parents who would like their children to attend college should start saving as early as possible. Many parents start saving once the baby arrives or soon before, but adults who know they want to have children can start setting aside money as soon as they make that decision. A 529 college savings plan is one of the easiest and best options for parents to save for college: It’s tax-free and can be used for qualified educational expenses for any of your children — even first cousins.

A 529 is a tax-advantaged college savings plan sponsored by all 50 states and the District of Columbia. It comes in two forms: Prepaid tuition plans and education savings plans. In the academic year 2019-20, 37% of families used a college savings account like a 529, up from 21% in 2018-19, according to Sallie Mae’s 2020 “How America Pays for College” report conducted by Ipsos.

“We encourage folks to inquire about 529s and work with representatives to get them started,” said Amy Nelson, Financial Wellness Coordinator for Nevada Money Mentors at the University of Nevada, Reno. “We see so many students who don’t understand the ways to pay for school to set them up for long-term financial success, and 529s are a great way to kick-start that financial success.”

While 529 plans may not have an age limit, depending on the state, some prepaid tuition plans and Coverdell education savings accounts (ESA) might have an age limit on the beneficiary or penalties for withdrawing early.

You might not be able to see the benefits of college savings plans right away, but over time, you can see your investment begin to grow. Take a look at the chart below. You can rollover the bars with your mouse to view the dollar amount for each year.

Let’s say your initial contribution is $1,000 for Year 0, and then every year, you contribute $1,000. There is an 8% interest rate and a 33% tax rate. By Year 2, you might have $2,054 in savings without tax sheltering. Tax shelters are ways to reduce tax liabilities, which include programs like 401(k) plans. With tax sheltering, you could have $2,080. That’s about a $26 difference, on average.

Now, fast-forward to Year 20. You can see a considerable increase: a 36% investment growth with tax sheltering. That's about $50,423, compared to $37,194 without tax sheltering.

College savings 529 plans, known as qualified tuition plans, come in two different forms: Education savings plans and prepaid tuition plans. Education savings plans have the most flexibility as they can be used for qualified higher education expenses for the beneficiary, or beneficiaries, of the account. They are custodial accounts, meaning that the account is in the custodian’s name, typically a parent. They are sponsored by states, state agencies or educational institutions and are authorized by Section 529 of the Internal Revenue Code (IRC).

Optimally, parents should start researching 529 college savings plans, which are available in most states, except Wyoming, and the District of Columbia, before they have children. Check out the College Savings Plan Network, which was created by the National Association of State Treasurers. It allows shoppers to compare the plans in each state.

Education savings plans are a way for families to pay for college and reduce a student’s future burden of student loan payments. A fund manager can work with age-based and enrollment-date investment portfolios, and they typically have a more aggressive portfolio at the beginning of a child’s life. They become more conservative as the plans get closer to term, so the earlier parents start a plan, the better. They are tax-free as long as the funds are used for qualified higher education expenses.

Another option is a prepaid tuition plan, which is available in 10 states. Parents can pre-purchase future tuition for their children at a predetermined rate today. The benefit is that you lock in current tuition rates, but the risks are, you have to purchase the tuition at a specific university — so if the student opts not to attend that school, the funds can transfer, but not at the current tuition rates instead of the locked-in rate.

A 529 is the optimal savings plan for those looking for tax cuts as it is entirely tax-free when used for educational expenses. Anyone can contribute to a 529 as long as they stay within the IRS tax gifting limit of $15,000 per person per year.

The great thing about a 529 plan is that, even if the custodian experienced a financial hardship and had to withdraw funds from the plan, the custodian would only pay tax penalties on the account’s investment gains.

One thing to keep an eye on is the IRS rules for qualified higher education expenses since they’re subject to change every year, said Karen Vibe, an Ameriprise financial adviser. She suggested saving receipts for any items purchased with 529 funds for tuition and fees, books, room and board, transportation and other educational expenses.

There are also tax breaks for married couples filing jointly (household adjusted gross income up to $130,000) and single individuals ($65,000) for tuition and fees. You can find tax guides for students and parents to help you navigate college expenses and tax benefits.

A 529 plan can only have one beneficiary at a time, but you can change the beneficiary. For parents with more than one child — especially if the children are four or more years apart — the question of whether to open one 529 for all the children, or a 529 plan for each individual child. This question can boil down to how much the parents plan to contribute to the plan each year. If they plan to contribute more than $30,000 to the plan each year (or if, for example, grandparents plan to contribute more than the annual gifting max), then opening multiple plans would maximize the tax benefits.

Just remember — You must use the 529 funds for qualified educational expenses, so no stashing away the funds to give to your child as a downpayment on a house or a car when they’re older, unless you want to pay steep tax penalties.

Since you can easily transfer the funds from sibling to sibling, there’s no risk of opening a plan for a child who may not attend college. You can also use the funds from 529 plans up to age 28, so you can use them for graduate school as well.

“Generally, the best idea is that you can transfer the funds within the same generation, so (the money is) very fluid,” Karen Vibe said. “You can flip the money back and forth between siblings and first cousins without any penalties. The last option is to pull the money out and pay penalties on the funds you don’t spend on education. Be very careful with that. I advise people to keep it among the kids and use it for other educational expenses.”

Each state offers different 529 plans, so make sure to comparison shop the plans available before you make a decision. Look at the performance of the plans and do some research into the plan’s fund manager. You’ll also want to make sure to look at the fund’s residency requirements, state matching grants, associated fees, minimum initial contribution and deferred earnings or withdrawal.

According to the College Savings Plan Network, the plan features include:

• Type (Savings plans vs. prepaid tuition plans): According to the College Savings Plan Network, “You should consider the flexibility of a savings plan account versus the tuition guarantee of a prepaid tuition account. Note that a prepaid account is designed for use at colleges in your state of residence (or the beneficiary's state of residence).”
• State Tax Benefits: Some states offer significant tax advantages such as a state tax deduction and deferral of taxes on earnings, which make the plan more attractive.
• Fees: Check the various commission and broker fees associated with each plan.
• Minimum Initial Contribution: Compare this among different plans to make sure you’re comfortable with the initial contribution requirement for the best 529 plan.
• Minimum Subsequent Contributions: Make sure the plan doesn’t require monthly or annual contributions that exceed your budget.

The best 529 plans are age-based blended plans in states with no state income tax or states with the best state income tax benefits, up to $20,000 for couples and $10,000 for individuals in Oklahoma and Illinois. An important note: Some states don’t offer multiple plans, so you could have only one choice depending on where you live.

Make sure to compare the prices and performance of the plans offered in the state you reside in. Plans can vary among states. Here’s a rundown of all the 529 plans available in the United States:

Starting a savings plan for your child can help to reduce college expenses later down the road. Here are a few frequently asked questions about 529 college savings plans.

There are many resources available to help parents research 529 plans. You can start your research with the College Savings Plan Network, which allows you to compare plans, then read more about tax compliance, restrictions, financial manager research and an expense analyzer.

College Savings Plan Network: My State’s 529 Plan: The College Savings Plans website offers a "529 Search & Compare Tool" that allows you to compare multiple plans at once and sort by state plans, plan type, plan fees, maximum contribution, minimum contribution, plan manager, investment manager and tax benefits & related information. If you use the map, you can get quick information on state benefits and tax information, financial aid benefits, state matching grants, reward programs, plan fees, contribution amounts and investment management companies.

U.S. Securities & Exchange Commission’s Investor.gov: This site offers investment product information, fees and financial calculators. You can research investment plan managers and investment professionals, and learn about their background and registration status.

Internal Revenue Service: “Frequently Asked Questions on Gift Taxes”: You can learn about gift tax issues and regulations here, as well as deductions, exclusions and more.

529 Expense Analyzer: The Financial Industry Regulatory Authority (FINRA) developed this tool that lets you compare two plans at a time. You can compare the holding period, investment amount, the annual rate of return, sales charges, other fees and more.