How to Save for College Effectively

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 Money put into an account is not counted towards your income for tax purposes, and if the money is withdrawn from the account to pay for the beneficiary’s educational expenses, it is not federally taxed at that time either, and is sometimes exempt from state taxes as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 If the money is withdrawn from the account for a reason other than approved expenses, it is subject to taxation, plus an additional 10% fee.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.