How to Open a 529 College Savings Plan for Your Kid
As you've probably heard by now,
How a 529 Plan Works
529 plans, named after the IRS code they fall under, are designed to
save for tuition and other education expenses
at U.S. colleges, universities, and vocational or technical schools (and some eligible schools overseas, too). Like other types of investment accounts, you save some
Unlike other types of investment accounts, these plans are state-sponsored, which means your options depend on the state in which you open the plan. (Confused? Don't worry, we'll get to this in a bit.) You also have to be 18 years of age or older to invest in the plan.
Why not just save for college in a boring old savings account? For one, interest rates in those accounts usually suck, and your money really won't grow thanks to inflation (in fact, depending on the rate of inflation, your cash could actually lose value over the years).
Aside from that, the biggest perk of a 529 plan is the tax advantage . The money you earn from investing in the plan isn't federally taxed and "generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board," the IRS explains . This means your money can grow tax-free. However, contributions to a 529 plan aren't deductible. This basically means you can't deduct the amount you save in a 529 from your taxable income, the way you can with, say, a 401(k) or a traditional Individual Retirement Account. But this also means that when you take money out of the 529 plan, you don't have to pay taxes.
Since 529 plans are state-sponsored, you don't set them up the same way you would other investment accounts. Almost all states have totally different 529 plans and some states have a few options to choose from ( look them up by state here ). The Wall Street Journal further explains :
"Each state picks a single administrator, like Vanguard, to run its plan and handle accounts for investors. These investment managers become, in effect, the brokerage firm for your
college savingsmoney. If you want to invest with the plan in your state, you have to work through the state's administrator. You don't have to invest in your state's plan, however-you can invest in any state's plan. But in general, you can a better income-tax deduction by contributing to your own state's plan."
You can also work with a financial advisor to choose a plan. You'll pay for the service, of course, but some people prefer the convenience of having someone else figure it all out for them. If you're already working with an advisor , this might be an easier option.
Either way, there are two general types of 529 plans (and states are allowed to offer both, although some don't): prepaid plans and investment plans.
With a prepaid plan , you pay for a year of tuition or course units in advance and lock in a rate. You're basically paying now to avoid any cost increases in the future.
, you choose how to invest the money you save and you also have the freedom to decide how you want to use that money. You still have to use it for educational expenses, but you're not locked into only using it for tuition or college units the way you would be with a prepaid plan. For that reason, most experts suggest going with the investment plan.
Most 529 investment plans then come with their own options: age-based plans or custom plans. With a custom plan, you choose how to divvy up your own assets (specific types of investments). With an age-based plan, your investment portfolio changes on its own as the beneficiary of the plan (your kid, grandkid, whomever) gets closer to college-age. Forbes writer Joseph Hurley suggests going the age-based route :
Still, your best option is probably the old standby: the age-based portfolio. By automatically reallocating their underlying investments from stocks to bonds and money market funds as your child gets older, your risk of a bear market decimating your college funding is reduced. Anyone having sent a child to college during either of the past two recessions would have been well off with the age-based option in their 529 plan.
How to Open a 529 Plan
Before you open your 529 plan, decide on the state. No, you don't have to open it in your home state-you don't even have to open it in your beneficiary's home state. You can typically open it in any state you like, as SavingforCollege.com explains :
Very few states will prevent you from using their 529 plans no matter where you live, which means you can shop among just about all the different plans...your choice of 529 plan has no impact on where your child attends college, either in-state or out-of-state. Of course, your state does not want you to go elsewhere with your college savings. That's why so many of the states sweeten the deal by giving something extra to residents. It could be a state income tax deduction for your contributions to the home-state plan, or matching contributions for residents below certain income thresholds, or a waiver of certain fees.
You might choose your state based on these incentives or you might choose to go to another state if they offer better plans. Savingforcollege offers a useful tool where you can compare your state's plan(s) with other states, including fees and investment options. Here's another website that breaks it all down.
In addition to fees and tax incentives, you'll want to compare minimum contributions and investment options. For example, check out how California's ScholarShare plan compares to New Hampshire's UNIQUE plan:
Once you pick your plan, read their program disclosure statement (PDS) to make sure you're familiar with all the rules and terms. In other words, read the fine print so you know what you're getting into.
The above-mentioned tools include links where you can enroll in specific plans; once you do, you'll need to name an account owner (aka "participant"), which is probably yourself. Not many 529 plans allow for joint ownership, but relatives and non-relatives can always gift into a 529 account.
You'll also have to name a beneficiary: the person receiving the money for college (your child, presumably). Keep in mind, it's the owner, not the beneficiary, who controls the assets in the 529. From there, you can usually link your checking or savings account to your 529 account so you can make regular, automatic savings.
Other Rules You Should Know About
Those are the basics, but there are a few other things you should know. For one, there are limits to how much you can contribute. According to the IRS, "contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary." Sounds pretty vague, right? It is, as insurance firm AXA points out (emphasis ours):
To qualify as a 529 plan under federal rules, a state program must not accept contributions in excess of the anticipated cost of a beneficiary's qualified education expenses. At one time, this meant five years of tuition, fees, and room and board at the costliest college under the plan, pursuant to the federal government's "safe harbor" guideline. Now, however, states are interpreting this guideline more broadly, revising their limits to reflect the cost of attending the most expensive schools in the country and including the cost of graduate school. As a result, most states have contribution limits of $300,000 and up (and most states will raise their limits each year to keep up with rising college costs).
Maybe more notable is the gift tax consequence. As the IRS explains, if your yearly contribution to the 529 plan (along with any other gifts) exceeds $14,000, you might have to pay a gift tax. (There is a way around this, though, which we've covered here .)
Also, it's pretty easy to change the beneficiary on your 529 plan. If your kid gets a scholarship and doesn't need all the money you've invested over the years, you could easily change the beneficiary to a sibling. Or you could just withdraw the money, as Fidelity explains :
"If the beneficiary receives a scholarship or attends a U.S. military academy, the scholarship amount or cost of attendance can be withdrawn from the 529 plan account and the 10% federal penalty tax does not apply."
The big caveat with this, however, is that the earnings are "subject to any other applicable taxes, including federal income tax," so you will lose that sweet tax benefit.