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.
Here’s everything you need to know about 529s.
TWO WORDS: TAX ADVANTAGES
When you use a 529, Uncle Sam will take less money so your children will have more for college.
- 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.
YOU NEED A CUSTODIAN
The custodian, otherwise known as the account holder, is the person who opens the 529 plan and controls the money in the account. Typically it should 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.
Likewise, avoid having a grandparent as the custodian, since any distributions will be considered untaxed income for the student on financial aid forms.
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.
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.
WHEN YOU SHOULD START SAVING
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.