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The best way to save for college, and how it fits your financial plan

Est. 12 min read
TL;DR Summary
  • 529 college savings plans are the best way to save for college.
  • There are drawbacks to the 529 plan, but pros outweigh cons.
  • A 529 plan is just one part of the big picture.

If you’re reading this, you probably want your kid to go to college (or your grandkid, or niece or nephew, or neighbor, etc.). But let’s say you you look at the current average annual cost of going to public college – $23,410and then you look at an estimate of what the cost will be in 2030 – $44,047and then, maybe, you freak out a little bit. You hear someone screaming and then you realize that you’re the one who is screaming.

Don’t fret (too much): there are great options that can help you save for a child’s college education, including our personal favorite, the 529 college savings plan.

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What the heck is a 529 college savings plan?

There’s a good chance you’ve heard of it before: 529 college savings plans are growing in popularity.

529 college savings plans are simple in concept; according to the U.S. Securities and Exchange Commission, they are “tax-advantaged savings plan[s] designed to encourage saving for future college costs.” Basically, the government wants you to save for your kid’s college tuition, and a 529 college savings plan is their incentive.

Usually, this plan takes the form of an investment account–similar to a 401(k) or IRA. While the 529 plan will eventually be used by a student (the “beneficiary” of the plan), you’ll stay in control of the account. So if your kid decides to go to clown college (a respected, but not accredited, institution), you can make your Harvard-bound niece the beneficiary instead.

Seems simple, right?

Unfortunately, 529 college savings plans are a lot more complicated in practice. It can be remarkably easy to get lost in the weeds. (Also, make sure not to confuse them with 529 prepaid tuition plans, which we’ll talk about later.)

There are basically two ways to open a 529 savings plan. The first is called a direct sold savings program. Direct sold savings programs are sponsored by U.S. states and usually administered by mutual fund companies. Your other option is a broker sold savings program, which are sold through financial advisors.

What’s the difference? Direct sold plans are usually cheaper. If you open your 529 savings plan through a broker, you’ll pay for their expertise with added fees. Other than that, plans are the same – you get all the tax benefits no matter where you open the account.

529 college savings planEach state has a unique 529 savings offering. There are small differences, like fees and minimum deposits, and there are large differences, like growth opportunity and tax deductions. Plus, each state usually has multiple options depending on how much risk you want to take. And, here’s the kicker that makes things even more complicated (but gives you more choice): you don’t have to live in the state to sign up for their 529 college savings plan.

So, if you were over here thinking, “Okay, I just need to compare my state’s plans to a few brokers in my state,” LOUD BUZZER SOUND. If you want to find the best deal, you have to compare all fifty states PLUS a few local financial advisors.

Actually, you can probably find a great plan without ever stepping into a financial advisor’s office. Since you can compare plans from all fifty states, you’re likely to find a plan that is low on fees, offers tax deductions, and delivers a great rate of return just by doing your own research online.

Where can you do that research? There are a few online tools that will help you out: AARP, Morningstar, CollegeSavings.org, and Savingforcollege.com all have tools that will help you compare plans from across the country. You also Google “top 10 state 529 plans” – there are usually a few articles published annually that track the best 529 plans.

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What makes a 529 college savings plan so great?

So many things.

1) It’s tax free

As long as you use the money from the 529 on qualified educational expenses, there will be absolutely no tax on your gains. This is really, really awesome, for some really, really obvious reasons. First and foremost, all of the money in your account will actually be useable; you won’t lose any to Uncle Sam.

2) It’s (mostly) gift tax free

Each person can contribute up to $14,000 every year ($28,000 for couples [see how that works? Hint: it’s doubled]) without hitting the gift tax. Want to quickly shed some money from your estate and into a 529 plan? You can give $70,000 (again, $140,000 for couples) right now, as long as you don’t give any more money in the next five years.

3) Financial Aid is in your favor

529 college savings planParental assets are assessed at a maximum 5.64% rate when determining your Expected Family Contribution, or EFC. The student’s assets, on the other hand, are assessed at 20%. This is another reason why it’s so great that 529 savings plans are owned by the account opener, not the beneficiary. Oh, and another benefit? The Feds won’t ask about a grandparent’s or relative’s 529 savings plan at all.

4) Oh, another financial aid thing

When you withdraw money from the 529 college savings plan, you don’t have to declare it as income on next year’s FAFSA form. Example: if you take out $40,000 to pay for your child’s college, it won’t raise your base income by $40,000 next year, and your EFC will not be recalculated based on an additional $40,000 in income.

5) Some states allow you deduct contributions come tax season

Depending on where you live, you could potentially deduct contributions from your state income tax forms (note: you cannot deduct contributions on federal tax returns). This usually counts for out-of-state plans, too, so even if you decide to go against your local option, you can still reap local tax benefits. These deductions can end up being pretty big, and often spur people into contributing more.

6) It’s easy to find a plan that matches your tolerance for risk

Most states offer multiple plans that match different levels of risk tolerance. Some are more closely tied to stock market and can potentially win big (or crash alongside it, depending on the year). Others are based on more stable investments, like bonds. Some states offer plans that automatically shift the amount of risk based on the child’s age – meaning that as your child gets older, the 529 plan features less risky investments, minimizing the risk that you’ll lose it all right before you need to make a withdrawal.

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Okay, well, there have to be drawbacks, right?

Oh yes, there are drawbacks.

1) If you overfund it, you might have to pay taxes to withdraw it

What happens if you put too much money in your 529 savings plan? Even if you fund it to exactly match the estimate of that year’s college tuition, there’s no knowing the exact tuition that year for whatever college your child chooses. Plus, your child could get scholarships, grants, or even a full ride. Then what?

Luckily, you have options. For starters, you don’t have to withdraw any or all of the money – since you own the account, you can save some for your other children, your nieces or nephews, or even save it for grandkids. And let’s say your kid gets some scholarships. Some of the time, you can withdraw a matching amount from the 529 plan without incurring taxes or penalties.

If you do want to withdraw, you will have to pay taxes, but only on the money you’ve earned. The money you put in – also called the “basis” – will never be taxed, since it came out of your post-tax paycheck. You’ll also have to pay 10% of your earnings as a penalty.

2) Withdraw more than you need? Taxes and fees (again)

529 college savings planLet’s say tuition is $40,000 and you accidentally withdraw $50,000. That additional $10,000 could be subject to taxes and fees. It all depends on how much of that $10,000 is “basis” and how much of it is “earnings” – any of the earnings will be taxes and subject to a 10% penalty. Now, you’re probably not going to accidentally withdraw an extra $10,000. So when would this come into play? Sometimes people try to claim education tax credits, such as American Opportunity, Hope, or Lifetime Learning, on expenses paid for with 529 money. Unfortunately, there’s no double-dipping on tax credit.

3) Fees can eat away at your gains

Just like any investment product, 529 college savings plans come with fees attached. Depending on the plan, you could end up paying an account maintenance fee and a program management fee, as well as sneakier fees, like a change of beneficiary fee or paper statement fees. Savingforcollege.com has put together a fee study of direct sold 529 plans, which you can use to compare costs across states.

4) There’s still some inherent risk

At the end of the day, 529 college savings plan are still investment products. While most states have plans that automatically shift more of the assets from stocks to bonds as your child gets closer to college, you’re still taking a risk by putting money in the stock market at all. Some states have plans that put money in interest accruing savings accounts, which are a lot safer than investment plans, though their growth potential is much, much lower.

What are my other options?

There are a ton of other financial products you can use to help save up for your child’s college education. In fact, we encourage it! 529 college savings plans are great for saving money to pay for tuition, dorms, books, and other qualified educational expenses, but your child won’t just have qualified educational expenses. There’s stuff like laundry, food, and other personal expenses that don’t qualify as educational.

Most people, according to the Wall Street Journal, use multiple accounts to help save for college, including the following options.

Savings Accounts

Yup – good ol’ American savings accounts. They have low interest rates, but they’re relatively stable (just be sure to find one with no fees). Plus, no limits on what you can spend it on.

Checking Accounts

Also good, old, and American. Even lower (if any) interest rates, often come with fees, and yet, according to the Wall Street Journal, it’s the third most popular financial product for college savings. While a checking account isn’t best for parents looking to save for their kids, it does make sense for a kid to have both a student checking and savings account that they can use to put aside their own college savings.

Outside investment [other than 401(k) or 529]

Whether you’re pouring your money directly into the stock market or your Vanguard fund, an outside investment has a lot of potential growth and a lot of risk. When should you consider an outside investment? Let’s say you have a large annual income – large enough that the $14,000 annual cap on gift-tax-free contributions to the 529 plan seems meager – and you want to put a considerable amount aside as a college fund. An investment vehicle might be your best bet in this case.

Credit Card Rewards

529 college savings planCredit card rewards can do a lot of magical things, like get you a free vacation and some gift cards. But did you know that there are credits cards that automatically deposit their rewards into a 529 savings plan? If you already use a credit card for most or all of your transactions, you’re aware of just how much cash you can get from rewards. While it won’t replace putting aside a portion of your income, it can provide a decent supplement. Check out Savingforcollege.com’s guide to college fund cards and Upromise, one of the largest rewards programs for college savings.

Retirement Accounts

As many as 1 out of 5 persons polled by Wall Street Journal say they’re willing to dip into their retirement accounts to help pay for their child’s education. Generally, we think this is a bad idea – your retirement fund should be your retirement fund – but in a pinch, it can provide some extra cash for unexpected expenses.

Certificate of Deposit (CD)

If you deposit your cash into a CD, you’ll get a higher interest rate than most savings accounts. Why? Because you can’t cash out until years later. If you don’t have enough money to make an investment worthwhile, but still want a higher growth rate than a savings account, a CD might be perfect for you.

529 Prepaid Tuition Plan

Okay, so we’ve talked a lot about 529 savings plans, but there’s actually another type of 529 plan: the 529 Prepaid Tuition Plan. How are they different? Instead of putting money aside, you’re using your money to buy tuition “units” directly for your home state. Say, for example, you take some money and buy a semester’s worth of tuition tomorrow afternoon. You’re buying that semester at today’s college prices, which may double or triple in the next eighteen years. But your semester unit is still worth a semester, no matter how much college costs go up. It’s an incredible value on paper, but there are some drawbacks. Usually, it will only fully cover your costs if your child goes to a public school within the state. If your child ends up going to a college in another state or a private school, you’ll be expected to make up the difference. It also only covers tuition, not other qualified educational expenses like room and board or books. Like 529 savings plans, details differ from state to state.

Coverdell Education Savings Account

Coverdell ESAs are similar to 529 saving plans – they’re both primarily investment vehicles designed to help people pay for educational expenses by reducing their tax burden – but they differ in some key ways. For starters, Coverdell ESAs are limited to a $2000 annual contribution. That may seem like a major limitation, but to make up for it, Coverdell ESAs have two big advantages over 529 saving plans: a) you can self-direct the investments in a Coverdell ESA and b) you can withdraw money tax-free to pay for K through 12 expenses as well as college expenses.

Savings Bonds

There’s a good chance that your child got (or will get) some U.S. Savings Bonds as gifts. Cool! Keep them around! Use them for whatever! We suggest, however, not investing in any more. It’s better to instead put that money in some sort of automated investing solution (like a 529 college savings plan) that already incorporates bonds.

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Before you go… make sure you have a back-up plan

There are two types of insurance you should look into to help guarantee that your child will be able to pay for college regardless of what happens to you: life insurance and long-term disability insurance. They cover two major disaster scenarios that could potentially happen: a) your untimely death or b) a disability that stops you from working. We strongly suggest that anyone who has dependents get life insurance today. After that, consider if long-term disability is right for you.

Published on July 17, 2015

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Adam Cecil writes for PolicyGenius, a digital insurance brokerage trying to make sense of insurance for consumers. You can read more of his writing on his site.
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