Average tuition and fees last year at public universities cost in-state students $9,410 and out-of-state students $23,893, while private college students paid $32,405, according to The College Board.
And that’s just for one year. If the current trend continues, those costs are likely to keep rising.
Consider the 529 college savings plan, a tax-advantaged investment account designed exclusively to help you save money now for when your kids go off to college in the future.
The plans are legally known as “qualified tuition plans” and are sponsored by state governments or educational institutions. The name comes from the corresponding Internal Revenue Code section that spells out its rules.
All 50 states and the District of Columbia offer at least one 529 plan. You can open as many accounts as you want in any state, no matter where you live.
There are no income restrictions for the account holder or the beneficiary or any annual contribution limits, according to the IRS.
However, you can’t contribute more than necessary to cover the beneficiary’s college expenses. Each state sets a lifetime contribution limit for its 529 savings plans, ranging from $235,000 to $511,000.
“It’s really an advantage for parents if they start early to help create a savings plan for their children so they’re in a better position once they graduate high school to pay for college expenses,” says Jolene Ignarski, a senior branch manager for Fidelity, which manages 529 plans in four states.
What is a 529 Plan?
There are two types of plans: prepaid plans and savings plans.
A prepaid plan lets you buy units of tuition from participating colleges and universities at today’s prices. This type of plan is designed to increase in value at the same rate as tuition — basically, you can lock in tuition at current rates.
These plans generally only cover tuition and fees, although some allow you to use excess tuition credits for other expenses, such as room and board.
These plans typically have age or grade limits for beneficiaries. Many state plans are guaranteed or backed by the state government.
There’s also the Private College 529 plan for private colleges and universities, which applies to 280 schools, including MIT and Vanderbilt.
“Private College 529 is a prepaid tuition plan that allows families to save on the cost of college by purchasing tomorrow’s tuition at today’s prices,” according to its website.
In fact, this credit card actually makes contributions to your 529 plan — just for using it.
A savings plan allows you to establish an account and choose investment options for a future student, but it won’t lock in the cost of college like a prepaid plan.
These savings plans are a bit more broad and withdrawals can generally be used at any college or university for tuition and mandatory fees, as well as room and board and required supplies, like books and computers.
Investment options include stock mutual funds, bond mutual funds, age-based portfolios, money market funds and others. As with other investment accounts, your money will grow or shrink with the market, so there is some risk involved.
States don’t typically guarantee these accounts. There are no age limits, which means adults and children can be named the beneficiary.
Tax Benefits Offered By 529 Plans
One of the best things about 529 college savings plans is anyone can contribute to them, making them especially popular among grandparents and relatives. They can literally give the gift of education for a birthday or holiday.
Another benefit is the accounts are exempt from federal income tax, and also frequently exempt from state and local income taxes, as long as you use the withdrawals for college expenses like room and board or tuition.
If you take money out of a 529 savings plan and don’t use it for college costs, you’ll pay income tax plus a 10% federal tax penalty.
With both types of 529 plans, if your child decides not to go to college, you can change the beneficiary on the account to another child or to yourself. However, the money you take out still needs to be used for college expenses.
If your child passes away, you won’t pay the 10% penalty for closing out the account, but you will have to pay income tax on any money you made.
Some states also offer other benefits — such as matching grants or account bonuses — to encourage you to start saving for college now.
These accounts can offer other tax benefits, too.
Grandparents who want to pass on some of their wealth to future generations might consider depositing money into a 529 plan. The money is removed from their taxable estate, and they can give up to $14,000 per year in gifts without being subject to the gift tax.
Is a 529 Savings Plan Right for You?
One thing to keep in mind when deciding whether a 529 plan is right for you: You can borrow for college, but not for retirement.
If you have a limited amount of money to save, it makes more sense to put that money into a retirement account than a 529 plan.
“If you think of it kind of like the airlines, who instruct you to make sure your oxygen mask is securely fastened before you help others, the same type of thinking prevails here, too,” says Margaret Munro, who wrote 529 and Other College Savings Plans For Dummies. “If you don’t have enough stashed to cover your retirement, where else are you likely to find the money?”
Both types of 529 plans are restrictive — you can only use withdrawals for college expenses. Other types of accounts are more flexible, so consider how you’d handle unforeseen circumstances requiring you to dip into your savings.
“Are you saving enough for other eventualities, like retirement, unemployment, illness, etc.?” Munro asks. “Savings that can be used for a variety of needs are often preferable to savings which are restricted to only certain uses.”
It’s also important to ask yourself if you’ll be able to save enough with your 529 plan to cover the entire cost of college, or whether you’ll need to use additional means as well.
Depending on who owns the plan, what school you/your beneficiary attends and your income, a 529 plan may hurt your student’s ability to get financial aid. Many of these plans have high fees, too.
Generally speaking, a student’s federal financial aid package will be impacted least if a parent owns the account, rather than the student or a grandparent.
That’s just for federal aid, though. Each college or university may have a different formula for putting together its own financial aid package, so it’s a good idea to check if you have a specific school in mind.
Overall, while a 529 plan may be a great savings vehicle for some families, it may not be for others, Munro explains.
“These accounts tie your hands, are costly to have and will very likely count against you at some point in the financial aid process,” she says.
Your Turn: Are you saving for your child’s college expenses?
Sarah Kuta is an education reporter in Boulder, Colorado, with a penchant for weekend thrifting, furniture refurbishment and good deals. Find her on Twitter: @sarahkuta.