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Should I Start a 529 Plan?

Oct. 28, 2014
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Paying for college can put a financial burden on families, especially those who have more than one child going to college at the same time. If you’re looking for ways to minimize this financial challenge, you might consider starting a 529 plan. As part of your long-term college savings program, it’s helpful to start squirreling away tax-sheltered money when your children are still babies.

By the time they’re ready to attend college, there should be a comfortable nest egg saved to help pay for school. If you decide to start a 529 plan, choose one that best fits your economic situation while giving you the best advantages.

Named for the Internal Revenue Service Tax Code section about education-related tax advantages, 529 plans are designed to make it easier for families to send kids to college. Congress established the program in 1996, but the plans are not federally insured.

“College saving plans allow a saver to establish an account for a student for the purpose of paying eligible college expenses,” says Teresa Clark-Jones, a Michigan State University extension educator. According to Clark-Jones, account holders can choose from specific investment options for their contributions. “These investment options include stock mutual funds, bond mutual funds and money market funds,” she says.

There are dozens of choices for state 529 plans. According to Clark-Jones, every state sponsors either a pre-paid tuition plan or a college savings plan. Each one is a little bit different, and several states offer more than one option.

“Participants are not restricted to their own state’s 529 plans,” says Clark-Jones. “Individuals are encouraged to shop and compare 529 plans from different states.”

Advantages to 529 plans

If you’re thinking about starting a 529 plan, you’ll discover that there are notable advantages. Robert Pozen, a non-resident senior economic studies fellow at The Brookings Institution, points out that some 529 plans have significant tax benefits for families who take advantage of them.

The plans “receive a significant tax subsidy: investment gains are free of tax, so long as the proceeds are used to fund higher education expenses,” says Pozen. “Adding to their appeal, many states also grant a credit or deduction for contributions to a 529 plan.”

There are other advantages. According to the IRS website, for example, one child can be the beneficiary of separate 529 accounts set up by different people.

Drawbacks to 529 plans

One notable disadvantage to 529 plans is that there’s no guarantee your savings will cover the tuition when your child is old enough to go to college. Your kids may need to apply for financial aid to make up the difference. Students looking for assistance applying for aid should check out our free FAFSA Guide.

For some parents, the requirement that the money be spent on approved educational expenses may pose a problem. What happens if you have an account, but your children don’t go to college?

“If the 529 account is ultimately not needed for education, the earnings will be taxed at regular tax rates plus 10% – a hefty penalty,” says Pozen. “While parents should start a college savings plan when their children are very young, they might fear that none of their children will attend college years later.” However, the named beneficiary can be changed if the students are related, providing a way around the penalty.

Alternatives to pay for college costs

While long-term savings and pre-paid tuition are options for many students and their families, some alternatives can be used in addition to or instead of 529 plans.

“There are a wide variety of additional grants and scholarships available to students with superior academic records, special interests and other qualifying characteristics,” says Eileen St. Pierre, an assistant professor at Oklahoma State University. “Certain corporations, professional organizations, religious organizations, foundations and financial institutions award financial aid.” Other alternatives to pay for college costs include student loans and work-study programs.

If you’re thinking about starting a 529 plan, consider how it will fit into your family’s financial picture now and in the future. For more information about the different 529 options available, read NerdWallet’s The Best 529 Plans By State.

Saving student photo via Shutterstock.