Personal Finance Essentials
Saving for College with 529 Plans
Here’s How to Make the Most of the
Best College Savings Tool Available
The Best Way to Save for College
Of all the tools available for college savings, Section 529 College Savings Plans are the most flexible, the most tax-efficient and the most consumer-friendly. They are authorized under Section 529 of the Internal Revenue Code, which permits states to establish college savings programs with special federal tax advantages for participants.
How 529 Plans Work
Contributions to a 529 plan are invested in mutual funds, earning market-based returns. All growth within the account is tax-deferred. When the money is withdrawn for qualified college expenses – including tuition, room, board, computers and books – the withdrawals are completely tax-free. This combination of tax-deferred growth and tax-free withdrawal makes 529 plans among the most efficient savings vehicles available to any investor.
Contribution limits per child are generous – set by each state, but typically well into six figures, with many plans allowing up to $370,000 or more per beneficiary. If the account grows beyond what is needed, any remaining balance can be redirected to another family member – a sibling, a parent, a grandparent or even a future grandchild – creating potentially decades of additional tax-free compounding. You can enroll in any state’s plan regardless of where you or your child lives, and the money can be used at any accredited college in the country.
Withdrawals not used for qualifying college expenses are subject to taxes on earnings plus a 10% penalty. However, even with that penalty, 529 plans remain highly efficient savings vehicles in most circumstances. In some cases – particularly for wealthy families looking to transfer assets out of their taxable estate – the combined tax and penalty rate of 529 withdrawals is still lower than what estate taxes would otherwise impose.
Choosing the Right Plan
You are not required to use your home state’s 529 plan. The most important factor in choosing a plan is the quality of the investment options and the fees associated with them. Some states offer a state income tax deduction for contributions to their own plan, but because state income tax rates are relatively low, the savings from this deduction are often modest. A plan with superior investments and lower fees in a different state will frequently outperform the benefit of a small state tax deduction. Consider all aspects before deciding, and read each plan’s prospectus carefully.
How Much to Contribute – and What to Watch For
The tax incentives of 529 plans can make it tempting to contribute as much as possible as quickly as possible. But be careful not to over-fund the account at the expense of other financial priorities – particularly cash reserves and retirement savings. A reasonable target is to fund the account to cover approximately 50% to 60% of the estimated present value of future college costs, preserving flexibility for other uses. As the child gets older and college plans become clearer, contributions can be adjusted accordingly.
Also, remember to reallocate the investments inside your 529 plan as your child approaches college age. The appropriate portfolio for a two-year-old is very different from the appropriate portfolio for a sixteen-year-old. Many plans offer age-based allocation options, but review whether those automatic shifts actually match your needs.
Grandparents and 529 Plans
There is no guarantee the grandchild will need the money – they might not attend college, or might receive scholarships. Family circumstances can change dramatically between a child’s birth and their 18th birthday. The parents may face financial difficulties and be tempted to use the college account for other purposes. The grandparent may need the money themselves for medical care or living expenses. And the number of grandchildren may grow beyond what was originally anticipated.
For most grandparents, the most effective approach is to keep the money in their own name and evaluate the situation when the grandchild actually reaches college age. At that point, if help is appropriate and affordable, write a check directly to the college or university – not to the grandchild or the parents. Payments made directly to educational institutions are not subject to gift tax limits. If there is concern about dying before the grandchild reaches college, an estate attorney can draft language directing that funds be placed in trust for that purpose.
