The 9 month journey is finally over and your child is here!  You know that sleepless nights and countless diaper changes are ahead.  At this moment, the last thing you are thinking about is his/her college tuition.  However, with the skyrocketing cost of education, it is important to acknowledge the earlier you prepare, the better off your child will be.

529 plans were established by the IRS to provide a tax-advantaged avenue to save money for education costs.  Many people are familiar with the prepaid tuition plans and believe that is all that’s available to them.  However, 529 plans also offer an education savings plan.  It is important to understand the differences between them to identify which is the better option for your child.

The 529 plan is controlled by an account owner and a single beneficiary is designated to that plan.

Tax Benefits

• 529 plans grow tax-free and upon withdrawal, are tax-free as long as they are used for qualified educational expenses.  If withdrawals are not used for qualified educational expenses, they are subject to 10% penalty on earnings and state/federal income taxes.
•  In some states, contributions can be state income tax deductible up to a certain limit.
• To avoid the “gift tax”, up to $15,000 of contributions can be made per individual to the beneficiary. The current exception is a one-time contribution of $75,000 that is “spread over 5 years” to avoid the gift tax yet takes advantage of compound interest with a front loaded contribution.
  
• You are not required to contribute to your state of residency’s 529 plan; however, some states offer more tax incentives if you do.  It is important to research each plan thoroughly and determine which 529 plan is right for you and your child’s needs.

Financial Aid

• On the FAFSA, the 529 plan is considered an asset owned by the parent versus the student.   Thus, the student’s financial aid is reduced by 5.64% of the 529’s total worth vs the normal 20% used on student owned accounts.
• Given a student with $25,000 in his 529 account, his financial aid would be reduced by $1410 (5.64%) vs the normal reduction of $5000 (20%) of student owned assets.

Contribution Limits

• There are total contribution limits per beneficiary which are between $235,000-$520,000 based on the state plan.
• The limit includes earnings as well as the contributions themselves.
• These limits represent the anticipated totals to cover the cost of future educational expenses.
• Some state plans may also have minimum monthly contribution requirements but they are often manageable for all income levels.
• Anyone can create a 529 plan (family, friends) and contribute to the same beneficiary.  The limit applies to the beneficiary not the individuals contributing.

Remaining Funds After Qualified Educational Expenses Are Paid

• If your child has finished college and there are funds remaining in the 529 plan, you are allowed to transfer the funds to a new beneficiary.  In order to avoid taxes and penalties, the new beneficiary must be a family member of the initial one.  It is important to review the IRS and state guidelines to determine the rules and restrictions placed on this transfer.
• If the child is planning on attending additional schooling after college, the money can be kept in the 529 and used for post college educational costs.
• If you have no other anticipated future educational expenses and no new beneficiary to transfer to, you can withdraw the money, which is subject to 10% penalty on earnings and state/federal income taxes.

Due to the significant differences for each state’s 529 plan, it is critical that you thoroughly research the details of each specific 529 plan.  You must determine which plan gives you maximum returns, tax benefits, and investment options and the best step forward towards your child’s education.

Although there are some complexities surrounding 529 plans, it is obvious that federal and state governments are encouraging people to start saving for their child’s future college expenses. Even with small monthly contributions, the funds that will accumulate, tax free, will be significantly more than those kept in regular bank savings accounts or those held in less tax advantaged accounts.   Over time, education costs will continue to increase and without preparation, your child will possibly take on substantial debt or even forgo attending due the cost.  Thus, in order to maximize your financial fitness, it is important to take advantage of any and all opportunities when they are presented to you.

“Achieving Freedom Through Financial Fitness.”

Disclosure: This site may receive compensation from the companies whose products I review. This site is independently owned and the opinions expressed here are my own.