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How to Save for College Effectively

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College is expensive. Increasingly, college is very expensive, with the average cost rising every year. We’ve written before about applying for financial aid and finding scholarships, but most families will still be expected to contribute to the cost of their child’s education, sometimes a great deal. 

Many parents begin saving for college education early, but are uncertain how or where to start. In this article we’ll go over one of the best ways to save for college: the 529 college savings plan. We’ll cover what the plan is and how it works, and how to make best use of it. We’ll also compare the plan to other options to help save for college, so you can find what works best for you. Let’s jump in!

What is a 529 College Savings Plan?

Legally known as a “qualified tuition plan,” 529 plans fall into two forms. The first are prepaid tuition plans, which allow for payment of tuition costs at current rates, but are tied to a specific state and university. These are usually associated with a state’s public university system.

The second form of a 529 plan is an education savings plan. This is a tax-advantaged savings account meant to be used for a beneficiary’s educational expenses. We will devote the bulk of this article to discussing this form of the plan. Whoever sets up the account is in control of the money, but the money must be spent for the beneficiary. While we generally refer to the account being used for college funding, it can also be used to pay for educational expenses in grades K-12, and other legitimate expenses related to education. This includes mandatory fees from the institution, and room and board while attending college.

The account is tax advantaged. Money put into an account is not counted towards your income for tax purposes, and if the money is withdrawn from the account to pay for the beneficiary’s educational expenses, it is not federally taxed at that time either, and is sometimes exempt from state taxes as well. If the money is withdrawn from the account for a reason other than approved expenses, it is subject to taxation, plus an additional 10% fee. There are fees associated with these accounts, but these can be reduced or waived. These depend primarily on the state which runs the accounts.

If you put more than $12,000 per year into an account, or have accounts in multiple states, then you may be investigated for tax avoidance. The maximum amount you can put into an account per beneficiary per year is $80,000 (or $160,000 for a couple).

There are no income restrictions to opening a 529 account. To open one, you must meet the following requirements:

  • Be a US resident
  • 18 years old or older
  • Have a US mailing or legal address
  • Have a Social Security number or Tax ID

Anyone of any age with a Social Security number or Tax ID can be the beneficiary of a 529 account. You can even set up an account with yourself as a beneficiary, if you want to save up to return to school in a tax-advantaged manner. 

In addition to the account creator, others are also able to put money into a 529 account. This way parents, grandparents, and others who want to help contribute to a student’s future educational funding are able to combine their resources effectively, without incurring a tax burden on themselves or the student.

The money in a 529 account is managed by a private fund selected at the state level. You do not have to invest in your own state’s fund; you can place your money in the funds of any state (though some states have residency requirements to invest in their 529 plan). Working with a financial expert to find the state fund that best suits your needs can ensure the best results. Some states have multiple funds available. You cannot move money between these freely, but generally only once per year, or when adding a new beneficiary to the account.

These funds generally manage small but reasonable returns, commensurate to investing in a mutual fund. While more traditional investments produce larger returns, they do not offer the same tax advantages of a 529 account.

While you can generally only get money out by paying for education, you can add new beneficiaries to an existing plan, allowing you to use a single account for multiple students. Thus, if you have multiple children, and one decides not to attend college but to begin working immediately, an account set up for them can be used to fund their sibling’s (or cousin’s or nephew’s) educations instead. In the event of an accident or death, you can also close the account without incurring the 10% penalty.

Other College Savings Methods

You can set up a trust to cover educational (and other) expenses. Generally, this is not ideal, as trusts have significant investments needed to set up and to operate. We recommend only using a trust if you intend to have more than $100,000 invested in the student’s education, and if you want the funds used for something other than education. 

529 plans are limited in what the funds can be used for. Some parents instead set up savings accounts or purchase stocks on their own to set up a savings fund for their child’s education. These options offer more flexibility in the disbursement and use of funds, but will count as income for the child, and are subject to taxation.

Gift taxes also apply to direct contributions of funds to students for college expenses. Indeed, directly giving a student money, or paying their tuition for them, can cause schools to recalculate their financial aid award for that student. Thus well-meaning parents and grandparents can sometimes negatively impact their child’s financial situation, even while intending to help.

To help illustrate the pros and cons of the various savings plans for college, here’s a chart which outlines the advantages and drawbacks of 529 plans, trusts, and savings accounts: 

529 Plan

Trust

Savings Account

Untaxed within the limits of the plan

Can be tax-deductible

Taxed

Administered by whoever set up the plan, beneficiary has no say

Administered by whoever set it up, or the beneficiary, or separate trustees (which can include the benefactor and beneficiary)

Administered by whoever has their names on the account

Must be used for education-related expenses for the beneficiary

Can be used for any expenses decided on by the administrators

Can be used to cover any expenses

Money can come from one or multiple sources

Money can come from one or multiple sources

Money must generally come from a single source

Money cannot be withdrawn without penalty

Money can be withdrawn by dissolving the trust, which may or may not induce a penalty

Money may be withdrawn without penalty

Can have multiple beneficiaries

Can have multiple beneficiaries

Can have multiple beneficiaries

Can impact a college’s financial aid award

Can impact a college’s financial aid award

Can impact a college’s financial aid award

We hope that this has successfully illustrated the various pros and cons of these three methods for saving for college. We believe that the 529 college savings account is the best option for most families. Trusts are a good option if ludicrous sums of money are involved, but due to their complication and the funds needed to set up and maintain a trust, they are excessive for what most families require. While savings accounts are useful, they can leave students with an unexpected tax burden, and lack many of the benefits of the 529 account.

Final Thoughts

College is expensive, and saving for it and paying for it weigh heavily on the minds of parents and students. We hope that by bringing these options to your attention, you are better informed about your college savings options, and better able to make the best choice for your own educational future.

While we are experts at college admissions, we are neither financial experts nor accountants. We recommend you consult with financial professionals when setting up any college savings plans, to make sure you make the best decisions for your circumstances.

If you want to consult with college admissions experts on preparing for or applying to college, you should set up a free consultation with us. We’ve mastered every aspect of the increasingly competitive field of college admissions, and are always happy to help you on your educational journey.

Need help with college admissions?

Download our "Guide to Everything," a 90-page PDF that covers everything you need to know about the college admission process.

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