Easy Money: How to set up a 529 college savings plan

Easy Money: How to set up a 529 college savings plan

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The cost of college continues to grow faster than our ability to pay for it, and shows no signs of slowing down. If you’re concerned about future college costs, you may already be considering a 529 college savings plan. But there are multiple types of plans and each state offers its own version, which can make the process of selecting and opening a 529 plan overwhelming.

We can help you figure out the process. Here’s how to set up a 529 college savings plan.

Understand the 529 plan basics

Before you open a 529 plan, you should understand how they work and why they’re preferable to a regular savings account or stuffing cash under a mattress.

Simply put, 529 plans are tax-advantaged savings plans designed to save for future college costs. You (and anyone else) can contribute funds that help pay for a beneficiary’s education. These plans offer much more value than the interest rates in a typical savings account, which won’t keep up with the rising cost of education. (By the way, you can find five easy ways to turbo-charge your savings account here.)

Depending on the type, you can use 529 plans to pay for public and private universities, trade schools, vocational schools, and, as of 2018, private primary and secondary schools. Funds can generally be used for tuition and fees, room and board and other qualified expenses like textbooks (restrictions may apply). You can open a 529 plan and name anyone as a beneficiary – a child, relative, close friend or yourself.

While your initial contributions to 529 plans are not exempt from federal taxation, there are federal and state tax benefits.

Unlike other types of investment accounts, 529 plans are offered and administered by states. Every state (except Wyoming, which participates in Colorado’s plan) offers at least one 529 plan, and some states offer multiple options.

Choosing a plan type

Prepaid vs. investment 529 plans

529 college savings plans come in two different types: prepaid plans and investment plans.

Prepaid tuition plans

Prepaid plans let you buy future college credits at today’s rates, locking in the cost of tuition. You select the number of semesters or college credits you wish to buy, and pay for them all at once or through installments. Many prepaid plans are restricted to in-state residents and must be used for in-state schools, but you won’t lose money if the beneficiary decides to attend school out of state. You can change the beneficiary or collect a refund. (Select plans may let you apply your prepaid tuition across state lines.)

The main upside of prepaid plans is that you’re safeguarding against the rising cost of tuition. In addition, you aren’t taking a risk, like you would with an 529 investment plan. The downside is that prepaid plans typically only cover the cost of tuition and fees, not room and board or textbooks. Only a limited number of states offer prepaid plans, and some of those are closed to new participants.

529 college savings plans

Investment plans are much more common than prepaid plans — and what you commonly think of when you hear the numbers 529. Contributions to investment plans are rolled into an portfolio of stocks, bonds and other securities that grows until the beneficiary withdraws funds to pay for college. As long as funds are used for qualifying expenses, all investment growth is tax-free. Investment plans are more flexible, and can be used for tuition and fees, room and board, textbooks and other qualifying expenses.

Investment plans come in two main types: age-based and custom plans.

  • Age-based 529 plans: Age-based plans gradually reallocate investments, shifting from high-risk, high-opportunity investments to conservative investments as time goes on. These reallocations occur automatically and reduce your risk of losing your money to an economic recession (here's how to prepare for one) or bad investment as the plan matures. This option is a good fit for people who want to “set it and forget it.”
  • Custom 529 plans: Custom plans offer greater control, letting you create and manage your own portfolio. These plans are suitable for individuals with investing experience who don’t mind actively managing the account. While they may be more risky than age-based plans, they have greater potential for rapid growth.

The main upside of investment plans is the potential for tax-free growth over time. Plus, they can be used to pay for more types of educational expenses than prepaid plans.

“The income and capital gains generated by the assets held in the custodial account are not subject to federal tax, so long as the distributions are used to pay for qualified education expenses,” said Ryan Firth, a Certified Public Accountant and president at Mercer Street, a financial and tax services firm.

Choosing a state 529 college savings plan

Once you’ve decided on a 529 plan type, you need to choose which state you want to work with. Contrary to popular belief, you can participate in most 529 plans across state borders. Some plans, particularly prepaid plans, will require in-state residence.

Make sure to research the tax benefits your state offers for 529 contributions.

“Many states provide a state tax deduction for contributions,” said Philip H. Weiss, Certified Public Accountant and principal at Apprise Wealth Management. “That benefit is typically only available if you contribute to the plan in your state of residence.”

State plans differ in terms of contribution minimums, maximums and investment options. You should carefully study the program disclosure statement of any plan you’re considering.

“When choosing plans, you should pay attention to the underlying costs and expenses associated with the plan as well as the types of funds you can invest in,” said Weiss. “If you don't get a state tax deduction for contributions, the most common choice is usually Utah, as the costs are low and the investment options are strong.”

In other words, look for low-fee plans with quality investment options. If you really need help choosing a plan, consulting with a financial adviser might be the logical next step.

Opening your 529 plan

Once you’ve chosen a 529 plan, you’ll have to enroll with the state’s designated administrator. Each state has its own administrator, such as Vanguard, that manages the 529 plans for investors. These administrators are essentially investment managers for your 529 contributions.

Applications can usually be completed online or by mail. When opening the plan, be prepared for the following:

  • Paperwork: You will need to provide personal information that may include your mailing address, Social Security number and birth date. You may need to provide banking information. You will also need to provide personal information for the beneficiary.
  • Beneficiary: Just like when setting up a life insurance policy, you will have to name a beneficiary for the account. You can name anyone as a beneficiary — a child, relative, friend or yourself. You can always change the beneficiary at a later time.
  • Successor: 529 applications will invite you to name a successor, who will manage the account if you die or become incapacitated. It may be optional, but it’s a good idea to designate someone you trust. If you don’t name a successor and something happens to you, the new owner may be decided in probate.
  • Fees and Contributions: Some 529 plans charge an application fee, and some require a minimum initial contribution. Check your plan’s requirements and be prepared to pay.

Remember, very few 529 plans allow joint ownership, so you will probably name yourself as the sole owner when you submit an application. If you’re married and the plan is for your child, this account could become a bone of contention in the case of divorce. Of course, each parent can set up their own 529 plan. You can also transfer your account to another owner at a later date.

Contributing to the 529 Plan

Once your prepaid or investment 529 plan is open, anyone can contribute to the account, including friends and family. (Here's some extra tips for grandparents looking to set up a 529 plan.) Most plans will let you contribute via check, one-time bank transfers or even automated monthly contributions.

“You can contribute to a 529 plan either by direct withdrawal from your bank account by sending a check to the plan sponsor for deposit into the account,” said Weiss.

The government doesn’t limit how much you can contribute to a 529 plan, but there are tax implications if you exceed a certain limit. In 2018, individual contributions of up to $15,000 per beneficiary are exempt from the gift tax. If you contribute more, you will have to report it for gift tax purposes when you file in 2019.

“Individuals contributing to a 529 plan should be aware that the annual gift tax exclusion applies, which for 2018 is $15,000 per beneficiary. Gift-splitting is possible, so a couple can give a total of $30,000 to each child in 2018,” said Firth. “Super-funding is also possible with 529 plans, whereby five years of gifting can be made in one year, so a couple could give $150,000 to each child in 2018.”

The state may also impose a maximum total balance that a 529 plan is subject to, though.

If you really want to maximize contributions, have your friends and family contribute to the 529 plan in lieu of traditional gifts for birthdays, holidays and more.

What about future contingencies?

Most 529 plans will allow you to continue to participate after you move to a different state, although you may not continue to receive state tax benefits.

If the beneficiary receives a scholarship, you can use your 529 plan to make up the difference, or withdraw the funds. If the beneficiary decides not to go to college, you can transfer the account to a new beneficiary or withdraw the funds. Withdrawals not used for qualified educational expenses will be subject to a 10% federal penalty tax, and any investment growth will be subject to income tax.

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