The biggest financial aid secret that everyone should take advantage of is starting early when saving for college. And one of the best—and earliest—ways you can do this is through a 529 plan.
What is a 529 Plan?
Named for a section of the Internal Revenue Code, a 529 savings plan is a program conducted through states and educational institutions with the goal of setting aside money for future college costs. While it’s never too early or too late to open an account, there are some considerations when choosing the right plan.
Benefits and Drawbacks of 529 College Plans
|Free from federal income taxes||Taxes on non-education-related withdrawal, plus 10 percent federal penalty|
|Can be transferred to another family member||Cannot have multiple beneficiaries on one account|
|Can be opened and contributed to by anyone||Some accounts have high minimums for contributions|
|Hands-off investment handled by the particular plan||Little control—investment firm handles specific mix of investments|
|Beneficiary doesn't have access to account—you do||Can have an effect on financial aid eligibility|
|No income or age limitations to open an account||Some state programs require child to use money by a certain age|
So how do you choose the right 529 plan? Here’s a walk through the process.
1. Start with Your State
Even though you can invest in states other than your own, you’ll want to consider looking in-state first. Income-tax deductions and tax credits are available in over half of the United States, so it’s best to check out plans in your own state first, as you may have benefits just for living there. For specifics on state plans, check out savingsforcollege.com, which offers state-by-state breakdowns.
Best rule of thumb: If your state offers a tax break, stay in-state for your 529 plan; if it doesn’t, look elsewhere.
2. Choose Between Two Types of 529 Plans
Once you have selected what kind of state you want your plan in, now you have to choose between these two types of plans: prepaid and investment/savings.
Prepaid plans involve contributing current tuition rates that get paid out at future costs when a student goes to college. However, they are a little more restrictive, since the program pays the future tuition at any of the state’s eligible colleges or universities (or what’s comparable to out-of-state or private schools), so if parents are thinking of sending their child to an in-state public university, a prepaid plan will probably be the way to go. Prepaid plans are also probably better for incoming students that have an idea of where they want to go to school, since they can lock in at a discounted rate.
Investment or savings plans enable people to save money on behalf of a beneficiary and are a little more flexible in nature. Money contributed to an account can be used to pay a variety of higher education expenses, including room and board. If you’re going the investment plan route for your college savings process, you’ll want to look for a state with program fees lower than 0.75%. This plan is better for parents who want to start saving early, like when their child is just starting school.
3. Compare Plans
Figure out what you want in a plan, and then compare and contrast plans across states.
Other factors worth considering:
- The ability to use funds at any college
- Protection from bankruptcy
- Tax-deferred growth on deposits
If you decide that you don’t like your plan, you do have the option of transferring all or any portion of your already-invested funds to another option. However, this can only be done once per calendar year.
Also, one way to avoid financial aid penalties later is for the person that takes out the account to be someone other than a parent (like a grandparent, aunt, etc.). This is one way parents can avoid reporting parental assets when filling out the FAFSA.
Top-Ranking 529 Plans by State
According to Savings for College, these are the top 10 states by investment performance as of June 2014—the lower the percentile, the better the ranking.
The Bottom Line
Investment programs like 529 plans are perfect for early birds trying to pay for that huge financial worm of college. There are many programs to consider, state by state, with some plans more beneficial for particular types of families, students, and situations.