The cost of higher education is already high and it’s likely to continue to rise. Knowing the best ways to save for college and starting early can save you in the long run.
529 plans, legally known as “qualified tuition plans,” are usually sponsored by states or state agencies, and are authorized by Section 529 of the Internal Revenue Code.
Ever wonder why these savings plans are called “529” plans?
It is because 529 plans are named after Section 529 of the Internal Revenue Code (IRC), which authorizes tax-free status for “qualified tuition programs.”
Earnings in 529 plans accumulate on a tax-deferred basis and distributions are not taxed federally when used for qualified higher education expenses.
Knowing about the two types of 529 plans is helpful: pre-paid tuition plans and college savings plans. All 50 states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a pre-paid tuition plan.
Investing in a 529 plan may offer college savers special tax benefits.
Earnings in 529 plans are not subject to federal tax and, in most cases, state tax as long as you use withdrawals for eligible college expenses. However, if you withdraw money from a 529 plan and do not use it on an eligible college expense, you generally will pay income tax and an additional 10 percent federal tax penalty on earnings.
Many states offer state income tax or other benefits, such as matching grants, for investing in its 529 plan. Make sure you review the plan’s tax rules before investing. Some transactions may have state tax consequences for residents of certain states.
Pre-Paid Tuition Plans vs. 529 Plans
Many people are confused about whether they should save using a 529 plan or a pre-paid tuition plan. There are some major differences between the two types of education saving plans.
Pre-Paid Tuition Plans
Pre-paid tuition plans generally allow college savers to purchase units or credits at participating schools for future tuition and, in some cases, room and board. Most prepaid tuition plans are sponsored by state governments and have residency requirements. Many state governments guarantee investments in pre-paid tuition plans that they sponsor.
- Locks in tuition prices at eligible public and private colleges and universities.
- All plans cover tuition and mandatory fees only. Some plans allow you to purchase a room and board option, or use excess tuition credits for other qualified expenses.
- Most plans set lump sum and installment payments based on beneficiary age and the number of years of tuition purchased.
- Many state plans are guaranteed or backed by state.
- Most state plans have age limits.
- Most state plans require either the funder or student to be a state resident.
- Most plans have a limited enrollment period.
529 College Savings Plans
529 plans generally permit a parent to establish an account for their child for the purpose of paying eligible college expenses. Investment options often include stock mutual funds, bond mutual funds, money market funds, and age-based portfolios that automatically shift toward more conservative investments as the student gets closer to college age.
Withdrawals from college savings plans can generally be used at any college or university. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.
- No lock on college costs.
- Covers all “qualified higher education expenses,” including tuition, room and board, books, etc.
- Many plans have contribution limits in excess of $200,000.
- No state guarantee. Most investment options are subject to market risk that may increase or decrease in value.
- No age limits.
- No residency requirement.
- Enrollment open all year.