By Liz Bernhard, CFP®, MBA
For many of us, our family finances include a saving strategy for higher education expenses for our children or grandchildren. Fortunately, there are many college savings tools available to help parents and grandparents plan for the future, including qualified tuition plans like the 529 plan. When my son was born, I opted to open and begin funding a 529 plan.
These plans are tax-advantaged savings vehicles traditionally sponsored by states and explicitly designed to encourage saving for future education costs. Here are five elements of 529 plans every parent and grandparent should know.
529 Plans Are Tax-Advantaged Accounts
Contributions to 529 plans grow tax deferred as long as withdrawals are used for qualified education expenses, and earnings in the account are not subject to federal income tax, and in some cases, state income tax. I initially funded my son’s 529 account with $5,000. Assuming I make no other contributions, if his account grows to $9,000 by the time he goes to college, and I use the funds to pay for qualified education expenses, there will not be any taxes owed on the $4,000 of growth in the account. Qualified education expenses include tuition, room and board, books and computers.
Some states also offer tax incentives for contributions. I live in Utah, and contributions to a Utah 529 plan are eligible for a 5% credit against Utah income tax.
Funds Can Be Used for More Than Just a Four-Year College Education
What if your child or grandchild doesn’t attend a traditional four-year college or university? All 529 accounts can be used for trade or vocational school, community college or graduate school. And as of the 2018 tax year, you can withdraw $10,000 per student per year to pay private school tuition for kindergarten through 12th grade. (For related reading, see: How Tax Changes Promote 529 Investments.)
It is also possible to change the beneficiary to a qualified family member, including the beneficiary’s siblings, parents, cousins, nieces and nephews, aunts and uncles, and even spouses. If your child receives a scholarship, you can take penalty-free withdrawals up to the amount of the tax-free scholarship. It is important to note, however, that the earnings will still be subject to income tax in this scenario.
If none of these are options, you can take a non-qualified withdrawal and pay income tax plus a 10% penalty on the earnings portion of the withdrawal. The principal will never be taxed or penalized.
529 Plan Funds Can Be Used at Schools Nationwide
I opened a Utah 529 plan (called "my529" in our state) for my son, but that doesn’t mean he has to go to a Utah school. He can go to most schools in the United States and even some institutions overseas. For instance, if he selects a school in New York, Michigan, California or even Cambridge in England, we can use the funds saved in his 529 plan to help pay for his education expenses.
Investing in a Plan Is Straight-Forward
There are a variety of investment options within each state’s 529 plan. Many plans have an “age-based” investment option where your asset allocation becomes more conservative as the beneficiary gets closer to the age of college attendance. Additionally, most plans provide the ability for the owner to pick and choose specific investments. (For related reading, see: Picking the Right ETFs for Your 529 Plan.)
One important note – you can only change your investment allocation twice a year, or when there is a beneficiary change. I opened my son’s 529 account when he was born and selected the age-based aggressive global investment option, which allocates the entire account balance between one domestic equity fund and two international equity funds until he reaches age seven.
Starting at age seven, the investment mix slowly becomes more conservative. Given our long-term time horizon (college is still 16 years away), we can accept the near-term volatility of the equity markets in pursuit of long-term growth.
Contributions Make Great Gifts
Each year on my son’s birthday, I remind our gift-giving family and friends that while clothes and toys are nice, a contribution to his 529 plan is the gift that keeps on giving. This statement rings true for young beneficiaries especially. The earlier you start saving for college in a 529 plan the more benefit achieved through compounding growth.
College is expensive, and the cost will most likely continue to increase, but saving for your child or grandchild's education in a 529 account can help alleviate some of the financial burden.
(For more from this author, see: Estate Planning: Not Just for the Uber Rich.)
This article was originally published on Investopedia.