The Ins and Outs of 529s: What You Should Know About College Savings

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Terrified of what college might cost by the time your child turns 18?

We can’t blame you. And if it seems like prices are far more expensive than when you went to school, you’re right: The average price of a private four-year college in the United States (including tuition, fees, and room and board) now tops $40,900 a year, a 14% increase in the last five years.

While these blistering increases show little sign of slowing, many parents who want to help their kids shoulder the expense of higher ed are looking for smarter ways to save.

One of the best places to start is with a 529 college savings plan. While there are a few other options to earmark savings for education, such as Coverdell Education Savings Accounts, “529s are almost always the best option for saving for college,” says Natalie Taylor, a CFP® with LearnVest Planning Services. “They have both flexibility and tax benefits that often make them more effective and wallet-friendly than other college savings vehicles.”

Since the plans were created in 1996, they’ve become an increasingly popular savings option. As of the end of 2013, more than 10 million Americans had invested nearly $204 billion in 529s, about six times as much as they had a decade ago.

But not every 529 is created equal—each state sponsors their own version (or two), and allows both local residents and non-residents to invest. That’s why we consulted CFP® Taylor, as well as Joe Hurley, founder of savingforcollege.com, a website that specializes in 529 plans, to help us figure out how a 529 works, what you should know about using this vehicle and how to find the right plan for you.

RELATED: How I Applied for 100 College Scholarships

What Is a 529?

529 plans, named for the section of the Internal Revenue Code that created them, are state-sponsored, tax-advantaged savings accounts that can be used to pay for qualified college costs—meaning tuition, fees, room and board, textbooks and even necessary technology. The funds can be used at any accredited school, public or private, anywhere in the country and occasionally overseas. Similar to a Roth IRA, money you contribute to a 529 will already have been subject to federal income tax, but once inside an account, the funds grow tax-deferred.

Most of the money in 529s today is invested in age-based portfolios, which are similar to target-date funds used for retirement savings. As a child nears college age, the investment mix gets more and more conservative. “It’s the ‘set it and forget it’ approach, where allocations are automatically adjusted as your child gets older,” explains Hurley. When the money is used for the approved expenses listed above, both your contributions and the gains come out tax-free.

All 50 states and the District of the Columbia currently offer at least one plan, sponsored by the state and typically managed by a financial services company. You don’t have to be a resident to invest in a state’s plan, but if you do choose your in-state option, you may be eligible for state tax deductions or credits.

RELATED: 9 Mistakes Not to Make With a 529 Savings Plan

  • Rob_Drury

    A few clarifications are in order. While IRC 529 doesn’t spell out the specifics well, 529 plan beneficiaries are generally limited to immediate family, dependents, or those within the account owner’s bloodline.

    One can participate in any state’s 529 plan. As the article suggests, there may be tax benefits to participating in one’s own state plan, but if the account owner lives where there is no state income tax, there are generally no tax benefits beyond those of other plans; so it may be beneficial to simply choose a plan that best achieves one’s other objectives.

    The article states that debt elimination and emergency savings should usually take precedence over funding a dependent’s education. I would suggest that retirement savings should as well. If one does not adequately save for a child’s education, there are likely still options available for funding that education. Inadequate retirement savings may be an unrecoverable situation.

    Rob Drury
    Executive Director,
    Association of Christian Financial Advisor
    Contributor to savingforcollege.com

  • CarrieSloan

    Hi Rob, Carrie from LearnVest here. Thanks so much for weighing in on this story. Just wanted to point out that we did also include making sure you’re on track with your retirement savings as a higher financial priority than saving for college in a 529, for just the reasons you mentioned.

    • Rob_Drury

      You’re so right, Carrie. I apologize for the oversight.

  • Adrienne

    Good article. I wish more articles about 529s would highlight that there is usually no holding requirement. For example, I am in New York and starting my doctorate. I put $5000 in yearly (the maximum deductible amount for singles) and withdraw it almost immediately to pay expenses. I still benefit from the NY tax deduction.