As the costs of higher education continue to rise, it’s never too early or too late to start setting aside money for college. In addition to traditional savings plans or bonds, there is a specific type of tax-advantaged savings plan that allows you to save money for education-related expenses for yourself or another beneficiary: the 529 plan (named for section 529 of the IRS code).
Most 529 plans are set up by parents as a way to save for their children’s college expenses. The parent, or other main contributor, acts as the plan’s owner. Many states offer plan owners full or partial state income tax deduction for their contributions to the state's plan. Each plan also has a beneficiary, the student, whom the funds will be used for, but who does not have any legal control over the account. As an added benefit, because 529 college savings plans are treated as an asset of the account owner, they have little impact on a student’s eligibility for financial aid if they’re owned by a parent.
The two types of 529 plans
There are two types of 529 plans: prepaid plans and savings plans. Prepaid plans allow the purchase of tuition credits for the future at current costs. However, these types of plans are administered by higher education institutions or states, and only 10 states currently offer this option.
The more common 529 plan type is a savings plan. They can offer higher rewards than a typical savings account, but it also comes with greater risks because the money is invested in mutual funds and thus exposed to market performance of the underlying assets. Like many retirement plan options, many of these plans offer automatic age-based asset allocations that become more conservative as the beneficiary gets closer to college age. While only states can offer these type of plans, plan assets are managed professionally either by a state treasurer’s office or an investment company.
What you can do with the money
The money in a student’s 529 plan can be used for qualified education-related expenses without being subject to income tax. Expenses that qualify include tuition and fees, room and board (including off-campus housing), books and other supplies (including computers) required to study at an accredited college, university, or vocational school in the United States, plus some foreign universities. Student loans and loan interest are not included. While money from a 529 fund can be used at any time, unlike a 401(k), any distributions from the fund that are not used for qualified expenses are subject to income tax and a 10% penalty on the gains.
When it’s time to set aside money for higher education, consider investing in a 529 college savings plan if you’re interested in a slightly higher risk but also higher reward option to traditional savings accounts.