If the cost of college makes you gulp — and, not to scare you, but it should — you may breathe easier when you realize there is a way to save for college that could help you save on your tax bill too.
The answer is a 529 plan. The arcane name comes from the section of the Internal Revenue Code that created it.
529 plans explained
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans are sponsored by states, state agencies, or educational institutions. They are authorized by Section 529 of the Internal Revenue Code. Earnings in a 529 plan grow tax-deferred, and withdrawals are tax-free if used for qualified education expenses such as tuition, fees, books, and room and board.
Here’s what you need to know about 529 plans and how they work:
529 Plans are tax-advantaged
When you use a 529, you'll pay less in taxes so you can save more for your child's college tuition. Your contributions grow tax-deferred. Withdrawals are free from federal income taxes as long as the money is used for “qualified college costs,” which include tuition, fees, room and board, books and even technology.
Your state’s 529 plan may offer, in addition, a full or partial state tax deduction, although this really varies by state. See how your state plan measures up to others with the plan comparison function at Savingforcollege.com.
While all 50 states and the District of Columbia offer at least one 529 plan, you’re not obligated to stick with your state’s plan, and your choice doesn’t have any impact on where your Studious Stella or Stanley eventually heads to school.
Most plans offer “age-based portfolios,” which means that the fund is more aggressive when your child is younger, in the hopes you notch some major gains, and then it will automatically adjust into a more conservative allocation the closer your child gets to college age, guarding against a nasty plummet that could wipe out your savings.
529 Plans require a custodian
A custodian (anyone, it doesn't have to be a family member) can open a 529 plan, as long as they are a US citizen or permanent resident and have a social security number or tax ID. The custodian, or account holder, is the person who opens the 529 plan and controls the money in the account. Often, it makes sense for the custodian to be the child’s parent.
Here’s why: If you make your child the account holder, the assets in the account will be more heavily factored into federal financial aid formulas. Translation: Your student may be awarded less financial aid.
If anyone else--for example, a grandparent or other relative--opens a 529 account on behalf of the child, any distributions will be considered untaxed income for the student on financial aid forms. However, due to changes to federal student aid forms beginning with the 2024 to 2025 academic year, students no longer have to report cash support on their FAFSA. This means distributions from a grandparent or other non-parent-relative’s 529 plan will not impact financial aid.
The money has to be spent specifically on educational expenses for the “beneficiary,” so that’s where you put your child’s name. If you have more than one child, you might want to set up separate accounts for each.
You can transfer a 529 plan if your child doesn’t go to college
All that saving and your child picks a career that doesn’t require college? Don’t worry, you can preserve the tax benefits by changing the name of the beneficiary, which is allowed once per year. You can designate any other relative — a lucky niece or nephew, perhaps — or you might decide that you’ve always wanted another degree.
If there’s no scenario under which you can use the 529 funds for educational expenses, all is not lost. You can still withdraw the money for any use, although you’ll have to pay the applicable income tax as well as a 10 percent penalty on money the fund earned. There are some exceptions to the 10 percent penalty, such as if the beneficiary becomes incapacitated. In addition, the penalty is waived if the beneficiary attends an academy that’s a branch of the U.S. service or gets a scholarship.
Start saving into a 529 plan early
It’s literally never too early to start saving: If you sock away $250 a month in a 529 plan for your newborn, you’ll have nearly $100,000 saved for college when your baby turns 18, assuming a 6 percent annual rate of return.
But it’s also never too late, so even if your kid’s current wheels are more of the real Jeep variety than a battery-powered model, you still might want to look into the benefits of a 529.
All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.