Everyone knows that college is expensive – and tuition costs continue to climb. For parents of young children, the idea of forking out tens of thousands of dollars for higher education is enough to make anyone break out into a cold sweat. With sufficient planning, however, it is possible to save for your child’s future while taking advantage of some really great tax savings.
The 529 plan has been around since 1996 and is named after the section of Internal Revenue Service (IRS) code under which it was created. Also known as “qualified tuition plans”, they come in two different types: pre-paid tuition plans and college savings plans. Regardless of which type you choose, 529 plans are managed by the individual states. Each state has its own rules and guidelines governing 529 plans, so make sure you work with an investment company familiar with the laws in your state. Just because you live in one state, however, does not mean you are prohibited from creating a plan in another state. Keep in mind, however, that certain pre-paid plans might limit you to using the funds to pay for tuition in a school located within that plan’s state.
Pre-paid tuition plans are pretty self-explanatory. Like the name suggests, you prepay future tuition into the investment plan and receive a guaranteed return rate in exchange. Many states impose residency requirements on the pre-paid plans they sponsor, which may limit the type of schools your child is eligible to attend. One of the advantages of pre-paid plans is the ability to lock in a current tuition rate. On the downside, your contribution generally limits the amount of available financial aid when your child enrolls in college. If, for example, you saved $20,000 in a pre-paid plan, that investment is deducted from the financial aid package offered upon enrollment.
By contrast, college savings plans tend to be more flexible and allow you to attend the school of your choice. Unlike pre-paid tuition plans, however, they do not offer a guaranteed rate of return. How much you earn depends on how your investments perform. In this sense, you are at the mercy of the market.
Both pre-paid tuition plans and college savings plan offer federal tax savings. Money invested in 529 plans is not subject to federal tax as long as it is applied toward college costs when it is withdrawn. Many states offer state tax exemptions on 529 plan earnings as well. College costs are generally broadly defined, which allows you to use the money to pay for just about anything related to higher education, including tuition, room, board, and books. If your child decides not to attend college, you can usually roll the account over to another beneficiary without penalty, including a spouse, family member, or an individual who has lived with you for at least one tax year. Expect to pay income tax and a 10% federal tax penalty, however, if you withdraw the money to pay for something unrelated to qualified education expenses.
A 529 plan offers many other attractive benefits as well. Unlike other types of investment products, most states offer a high contribution limit, with total maximum contributions usually capped at $200,000. Take care not to contribute too much to any single 529 plan, however, as the tax-deferred status is only available for the total amount of funds necessary to pay for education costs. If your plan has $100,000 sitting in it but your child’s education will only cost $60,000, you will most likely have to pay taxes and penalties on the remaining $40,000. Because you cannot share a single account among multiple beneficiaries, you are better off creating several separate accounts for each of your intended recipients. You can also take advantage of the annual gift tax exclusion as long as your yearly contribution is $13,000 or below. With a 529 plan, you also retain control over the funds, as opposed to other types of investments that shift to the beneficiary once he or she reaches a certain age.
With thorough research and proper planning, a 529 plan can be a sound investment for parents looking to defray some of the costs associated with paying for college.
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