Now’s the time to start saving for your child’s higher education, and a 529 plan, named after Section 529 of the Internal Revenue Code, is one way to put aside funds so you won’t get caught without college savings when the time comes.
529 plans are nationwide, tax-advantaged saving vehicles that let you finance your children’s college in Vermont even if you live in California. Although each state can decide whether it wants to offer a 529 plan, all do. And so long as the plans follow certain rules, federal law provides several tax breaks to plan participants.
Here’s how they work.
529 prepaid tuition plans
These plans let college savers buy units or credits that pay for future tuition, and sometimes room and board, at participating higher education institutions. Most prepaid plans have residency requirements and are guaranteed by state governments.
Prepaid plans:
- Lock in tuition prices.
- Set lump-sum and installment payments based on the age of the student and the number of years of tuition purchased.
- Set an age/grade limit for the student.
- Have a limited enrollment period.
529 savings plans
These plans permit a saver to establish an account for a student to pay for his or her college expenses. The saver chooses among several investment options, including stock and bond mutual funds, money market funds, and other conservative investments. Withdrawals from the account can generally be used at any college or university, regardless of location. Savings that are invested in mutual funds are not guaranteed by the state or insured by the federal government.
Many savings plans accept contributions in excess of $200,000, although investments are subject to the ups and downs of the market. They have no age limits and no residence requirements, and enrollment is open all year.
529 tax breaks
Earnings from 529 plans are exempt from federal taxes, and in most places state taxes, so long as you use the funds for tuition, room and board. But if you withdraw the money and don’t use it for college, earnings generally will be subject to income tax and an extra 10 percent federal tax penalty. Any money that you put in a 529 plan is after tax money, so you aren’t able to take a deduction in the year that you put the money in the plan. The advantage is that your savings grow tax free.
Don’t forget the fees
Fees typically accompany 529 plans. Prepaid tuition plans charge enrollment and administrative fees in addition to “loads” for broker-sold plans. 529 savings plans may charge enrollment and annual maintenance and management fees. You sometimes can avoid certain fees if you maintain a large account balance, make contributions automatically or live in the state sponsoring the plan.
What happens after you die?
If you die before your beneficiary does, your 529 account doesn’t; it just continues under the successor you named when you filled out the application for the account. If you don’t name a successor, a probate court might. The new owner will have all your rights, including the right to withdraw money from the account. So make sure you name someone whom you trust to carry out your wishes for the account.
What happens if your beneficiary doesn’t go to college?
You can change the beneficiary to another member of the family, moving up or down the family tree until you find someone who wants to use the account for college. You can even pass down any remaining money from generation to generation.
Or you can take back the money from the 529 and pay taxes and penalties on earnings.
Each state’s plan may be different, and there are many other rules governing them, so be sure to get qualified advice before proceeding.
