How Does a 529 College Savings Plan Work?
A 529 college-savings plan is a type of investment account specifically designed for saving for future educational expenses. 529 college savings plans can help make college more affordable. A 529 plan operates much like any other type of savings’ account when it comes to the mechanics of making deposits and withdrawals, but it also has some unique features. 529 college saving plans work a lot like Roth IRAs. The money you invest is tax-deferred, and withdrawals are free of federal income tax, as long as the money is used for qualified education expenses like tuition, books, school supplies or room and board at an eligible institution.
Anyone can contribute to a 529 plan including parents, grandparents, or even yourself if you’re saving for your own education. Investments to the plan can grow over time without paying taxable dividends. There are no income limitations and any investment gains in a 529 are generally not taxed when they’re withdrawn as long as the money is put towards qualified educational expenses as mentioned above.
529 college savings plans can be a good way to start saving, especially for young parents because 529 college savings plans offer families the opportunity to save for college in a tax-favored way. Here are five common myths surrounding college saving plans, along with the realities of these college-savings accounts.
Myth #1: “I can only use my own state’s plan”
Reality: This is one of the most commonly believed myths surrounding college saving plans. You’re not restricted to investing in just your home state’s plan; investors can use any state plan they’d like – and there are upwards of 50 plans available nationwide. So, if your child does eventually go to college out of state or even abroad, you don’t have to worry that your college savings won’t go where they’re needed. A majority of states offer a tax deduction or credit for contributions to college savings plans. These tax incentives help to entice college savers by providing an upfront savings on college costs. While your own state may not offer a deduction or credit, there are states that will allow you to claim the deduction even if it is not offered in your home state.
Myth #2: “I don’t have enough money”
Reality: College savings plans are only for high income earners. 529 college-savings accounts appeal to a large cross section of the investing public, not just those that have high incomes or large portfolios. In fact, college saving plans don’t require you to invest a minimum amount each year – and if your child doesn’t attend college there is no penalty associated with closing your account. 529 college savings plans can be an effective long-term tax advantaged vehicle for saving for college.
Opening a college savings account doesn’t mean you have to make a huge immediate investment, but you can make higher contributions as compared to a Roth IRA. For example, the maximum contribution in California allows up to $529,000 per beneficiary for a 529 savings plan whereas a Roth IRA has an annual contribution limit of $6,000 ($7,000 if you are age 50 or older).
Myth #3: “I don’t want to pay more taxes later”
Reality: Your college savings won’t be taxed, regardless of your income level. 33 states waive state income taxes on account earnings when the funds are used for college expenses. You can also make tax-deductible contributions to most other college saving plans as well. A 529 plan is just one of the college investments accounts available today, but with a 529 plan, the investments made can continue to grow while withdrawals for education expenses are tax-free as part of the U.S. tax code. Likewise, college savings plans like the 529 offer an advantage over other college investment accounts because you may not have to pay capital gains tax on withdrawals when those funds are used for college expenses. On the other hand, a custodial account is less restrictive when it comes to tax-free withdrawals. For example, for a tax-free withdrawal under a 529 plan, the money must be used for education expenses, whereas money withdrawn from a custodial account has tax-free benefits if money is used solely for the benefit of a child.
Myth #4: “I can only use college savings plans once”
You can open a 529 college saving plan for yourself or your child – but you’re not restricted to using it just once. In fact, each state allows users to open multiple accounts per person. So, if you have several children heading off to college in several years, or even generations down the line, you can fund college savings plans for every child in your family. There are actually three kinds of college savings plans: college savings plans, prepaid tuition plans, and 529 college savings/investment plans. Each has its own unique benefits and risks. The best way to do that is to ask a financial advisor about how to best utilize college savings plans, prepaid tuition plans and college savings/investment plans in your college funding strategy.
Myth #5: “You can borrow from your 529 college savings plan”
While 529 college savings plans aren’t designed to be regular savings or checking accounts, some states do allow college savers to tap into college saving funds for college expenses. However, thisisn’t the purpose of college savings plans and there are usually fees associated with withdrawing from your college-savings plan early. If you withdraw from a college savings plan and do not spend it on college costs, the earnings could be subject to income tax and possibly a 10% penalty if taken before age 59 ½. There is an exception to that rule that if you spend the money on educational expenses during any of the years the beneficiary attends college (even if he or she takes time off between high school and college) the penalty may not apply.
A 529 college savings plan is a great way to save for future higher education expenses because there can be higher contributions compared to a Roth IRA, and the earnings can grow tax-deferred. In addition to that, account owners aren’t taxed on withdrawals if the funds are spent on qualified education expenses such as tuition, room and board, books and supplies.
In recent years, college savings plans have taken on more visibility as an investment vehicle, and more Americans are taking advantage of the tax benefits that come with these college-savings accounts. In fact, according to Fidelity Investments’ 2020 College Savings Indicator Study, parents plan to cover an average of 65% of the total cost of college, which is up from 62% from 2018.
The study also found that 90% of families who are working with a financial advisor have started saving for their children’s college expenses. All this is good news for students who will one day head off to college or other post-secondary education programs. Since not all savings plans are considered financial aid, a financial advisor can help you decide which college savings plan is best for you.
Moreover, prior to investing in a 529 plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.