If you envision sending your child to college, you had better start saving. The increases to college tuition and fees currently outpace inflation and this trend is expected to continue. A public four-year college charges, on average, $7,020 per year for in-state tuition and fees. Multiply that figure by four years and today's parents are looking at $28,080 per degree. Going to a private school is typically even more expensive. (Save thousands of dollars on tuition with these tricks and little-known programs. For additional reading, see Pay For College Without Selling A Kidney.)
Fast forward 18 years and that same college experience - for tuition and fees only - will cost $105,347, assuming that the annual college tuition increase will be approximately 7%. Thinking of four years at a private college? In 18 years, you can expect to pay about $394,271. Aside from saving for retirement, squirreling away enough money for your child's (or - gulp - children's) college education will be most parents' biggest financial challenge. And just like saving for retirement, the sooner you start planning for your child's college education, the better. A college savings plan can help families prepare and set aside money for future college costs.
A 529 college savings plan is a tax-advantaged plan that allows families to save for future college expenses. These are typically state-sponsored investment plans, and each state has different requirements and benefits, including tax breaks. Every state has at least one 529 plan, and you do not have to be a resident of the state to invest in its plan. In fact, you could live in New York, invest in a Florida plan, and send your child to college in North Carolina. There are two types of 529 plans: savings and prepaid plans.
529 Savings Plans
These plans work similarly to other investment plans, such as 401(k)s and IRAs, in that your contributions will be invested in mutual funds or other investment products. As a state-sponsored investment plan, the state coordinates with an asset management company (such as Vanguard) to handle the investment according to the state's plan features. The owner of the account (i.e. the parents) deal directly with the asset management firm, rather that with the state. The beneficiary (for example, your child) is the person for whom the account is set up and who will use the money for college.
529 Prepaid Tuition Plans
Prepaid tuition plans, also called guaranteed savings plans, are administered by states and higher education institutions. These plans allow families to prepare for college expenses by prepaying tuition locked in to today's tuition rate. The program then pays future college tuition and mandatory fees at any of the state's eligible institutions. If the student goes to an out-of-state or private college or university, an equal amount of money will be distributed. Tuition can be purchased in terms of years or units, either as a one-time lump sum or through monthly installment payments. The program pools all contributions and makes investments to grow the plan. (Before you fund one of these education-savings vehicles, be sure you know their differences. To learn more, read A 529 Plan Fit For An Ivy League Education and Choosing The Right 529 Education Savings Plan.)
Specifics like minimum initial contribution, minimum monthly/yearly contributions and tax benefits vary from state to state and even between plans within each state. All withdrawals for qualified education expenses from 529 plans are free from federal income tax and in many cases, free from state income tax as well. Other state incentives may exist, including deductions for contributions, matching grants and scholarship opportunities.
What Can the Money be Used For?
Withdrawals from 529 savings plans can be used for qualified higher education expenses, including tuition, fees, books, supplies and any equipment required by the college. Room and board may be a qualified expense if the student's attendance meets the specified requirements. Certain expenses for special-needs student may also qualify. Withdrawals from 529 prepaid tuition plans can be used for tuition and mandatory fees only.
Do Students Have to Choose an In-State College?
No. Funds from 529 plans can be used at any institution that is eligible to participate in the U.S. Department of Education student aid programs.
What Happens to the Money if the Beneficiary Never Goes to College?
The account owner can change the beneficiary to a different member of the beneficiary's family. The funds can also be withdrawn as a non-qualified distribution, and earnings will be taxed by the state and federal government, plus a 10% federal tax penalty on the earnings.
What Happens if the Beneficiary Earns a Scholarship?
The funds can be used to cover expenses that are not covered by the scholarship but that still qualify as higher education expenses, such as room and board. Any amount that is withdrawn for non-qualified expenses is taxed at the scholarship recipient's tax rate, but the 10% federal tax penalty does not apply. For prepaid plans, the tuition benefits can be transferred to another member of the family, or refunded to the purchaser on a semester-by-semester basis. Either plan can also be held for future use. (Securing funding for your education isn't always the easiest thing to do, but there are some ways to get assistance. For more information, see Attend Grad School For Free.)
What if I'm Not Happy with the Investment in a Savings Plan?
You can change the investment option (for example, change an aggressive plan to a more conservative one) once in every calendar year. Each time you make a contribution you can choose a new investment option for the "new" money.
What are the Other Tax Benefits?
Individuals can contribute up to specified dollar limits per year, and married couples filing jointly can give double that amount without paying gift taxes or filing a gift tax return. In addition, five years' worth of annual contributions can be made during one year per beneficiary, which can be advantageous in certain situations.
What Are the Risks Associated with 529 Plans?
The risks differ depending on the type of plan. Prepaid plans are usually guaranteed or backed by the state. Savings plans, however, are not guaranteed and are subject to market risk. In other words, the investment could make no profit or it could even lose money. Different plans offer varying degrees of risk.
What Kinds of Returns Can I Expect?
Just like with any investment, what you expect and what you actually earn can be two different things. You can research each plan's historical performance by doing a little homework. Vanguard, for instance, lists its plans and corresponding performance statistics on its corporate website.
The Bottom Line
It's disheartening to imagine that college costs will continue to rise, and that by the time a now one-year-old is ready for college, a four-year degree at a public, in-state institution will cost over $100,000. College savings plans allow families to take an active approach to saving for future expenses, while benefiting from certain tax advantages. If a family decides that a 529 savings plan or prepaid tuition plan is right for them, it is important to stop procrastinating and get the ball rolling. The sooner you enroll, the easier it will be to meet your financial goals for college savings.
If you are looking for more information about college saving programs, Investopedia's Ask an Advisor tackles the topic by answering one of our user questions.