You may have heard about a type of tax-advantaged college savings plan known as a 529 plan. Similar to an IRA or 401(k), money put into a 529 is “qualified,” meaning it grows tax-free and can be used tax-free in the future.

You will find 529 plans sponsored by all 50 states and the District of Columbia. Yet not all 529 plans are created equal in terms of cost and investment offering.

The good news is anyone who wants to save and invest for a child’s education can use the 529 plan of any state without having to live there. Because of the wide variety of options and fees from state to state, it pays to shop around.

If you expect to finance an education in the medium-term future — say, more than 10 or 15 years from today — the power of tax-deferred compounding can be very attractive. In a 529 you can invest without having to pay taxes on reinvested dividends and gains in investment value.

Because of this feature, money placed in a 529 plan should grow more quickly than it would in a taxable account with a similar return.

The big bonus is that when it comes time to withdraw the money it remains free of income tax at the federal and state level, so long as it is spent to pay for educational needs. That means tuition, fees, textbooks, supplies and equipment, special needs services and, within limits, room and board.

There is no income phaseout and no federal limit on how much you can set aside in a 529, other than bumping up against gift-tax limits. States generally set lifetime maximum contribution limits based on the current cost of an education in that state.

You can get creative on funding sources, too. Some families rely on gifts from older relatives to pump up the plans of grandkids, money which can be considered a tax-free gift. You might be eligible for a deduction on your state income tax for contributions to a 529 plan, and some states offer matching grants in their plans.

A tax advisor can help you understand the rules of your chosen plan, its benefits and requirements.

Just like with an IRA or 401(k), there are rules about how and when you can take money out. Withdraw too soon and you might face a penalty. Use money for non-educational needs and you could be on the hook for state and federal taxes, plus a 10% federal tax penalty on earnings in the investments.

If your child ultimately does not go to college or if money is left over in the account, the balance can be used to benefit another family member’s educational needs. Changing beneficiaries is easy and penalty-free among family members.

Crucial decisions

Having a generous 529 plan balance can affect need-based financial aid calculations, since these are assets available for tuition, fees and room and board.

However, if custodial parents own the plan, aid is only reduced up to 5.64% of the account value. Since only a small amount of the 529 plan is counted and none of the withdrawals, custodial parent-owned 529 plans generally have the least impact on your child’s financial aid package. Plus, having these investments set aside also can reduce a future student’s dependence on educational loans

Often, the ultimate impact in needs-based aid calculations is negligible once you consider the advantage of tax-deferred savings and investment growth. I find that some parents focus on the potential downsides of a 529 as a reason to skip using them, to their own detriment!

Fees can vary from state to state. Be sure to ask if the plan you are considering is “direct sold” by the state. Direct-sold plans are cheaper as there are no brokers involved to add on fees.

States also sometimes discount plan costs for residents, those who make automated contributions, and for participants willing to accept electronic document delivery. A notable recent change in tax law allows 529 money to be used to pay for private school tuition at the elementary or secondary school level, rather than just college.

There are risks, as with any investment. While states sponsor 529 plans they do not guarantee the investments inside those plans, though cash balances may be protected by FDIC insurance.

Making college education costs part of your long-term financial planning can be a crucial decision. Too often, parents defer their own retirement savings to help their kids get a leg up, only to find out later that they must keep working in order to retire.

Carefully considered, a 529 plan can be a real resource for financing a child’s future educational needs. Taking advantage of tax benefits and investing early can give you the resources to be generous with your kids and still enjoy a secure retirement.

Send this to a friend