When it comes to saving for college, 529 plans are one of the best tools out there. But what exactly are 529 plans, and how do they work?
529 Plans Defined
A 529 plan is a special type of tax-advantaged college savings account. Much like a 401(k) allows you to put money away for retirement and get a tax break, a 529 plan lets you set aside money for higher education expenses while also saving on taxes.
Each state (plus the District of Columbia) offers at least one 529 plan option, and sometimes more than one. Some state 529 plans are open only to that state's residents, while others are open to anyone.
Two Types of 529 Plans
There are two main flavors of 529 plans. The first is a savings plan, where you choose from a range of investment options, such as mutual funds and bonds. Some 529 plans offer age-based options (much like a target-date retirement fund), which usually invest aggressively when the beneficiary is young and adjust to more conservative investments as your child's enrollment date nears.
The second type of 529 is a prepaid plan. Prepaid plans allow you to purchase credits today for future tuition at a state university. (There is also an independent prepaid 529 plan that can be used for tuition at certain private colleges and universities.) A prepaid plan lets you lock in tuition at today's presumably lower rates. Prepaid plans aren't as portable as 529 investment plans, however. If your child chooses not to attend your state university, you will be able to use the plan money for tuition at an out-of-state or private college. But if your child decides not to go to college at all, you may only get back your original contribution amounts if you contributed to a prepaid plan. Also important to note: Ohio's prepaid tuition plan, called the Guaranteed Plan, is currently closed to new accounts.
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The Tax Advantages of a 529 Plan
Contributions to 529 plans aren't deductible from your federal income taxes. Some states allow you to deduct contributions made to their plans from your state taxes if you are a resident. If you live in Ohio, you can deduct $2,000 in 529 plan contributions per beneficiary per year. In other words, if you have two children and put $2,000 in a 529 plan for each child, you can deduct $4,000 from your state income taxes.
Any money you invest in the 529 plan grows tax-free, and you won't pay income tax on withdrawals, provided they are used for qualified education expenses.
Choosing a 529 Plan
Choosing a 529 plan isn't as simple as just signing up for your state's offering. You need to approach your decision-making process like you would any other investment. State tax breaks are certainly something to consider. But you'll also want to look at the fees and expenses each plan charges. High fees will eat into your return and ultimately leave you with less money to pay for college.
If you live in Ohio, you may start your 529 plan search by looking at the state's plan, called the CollegeAdvantage 529 Savings Plan. There are two ways to enroll, a Direct 529 plan and an Advisor 529 plan (which is for brokers and includes commissions). We use the CollegeAdvantage Direct 529 Savings Plan, which features a wide menu of funds from The Vanguard Group plus FDIC bank insured savings accounts and certificates of deposit. The Ohio CollegeAdvantage Direct 529 Savings Plan is one of the best rated 529 plans in the country.
Another factor to evaluate is the available investment options. Plans may offer age-based choices, socially responsible investment options, bond funds, CDs and more. The right investment choice for you depends on the age of your child, your comfort with risk and other factors.
In addition to investment options and fees, you should look at any age restrictions, maximum and minimum contributions, whether the plan will accept contributions from other people (such as grandparents), policies regarding account and investment changes, online access and customer service.
A Few More College Saving Tips
You don't need to be a parent to open a 529 account. If you plan to have a child in the future or may want to go back to school yourself, you can set up a 529 account and name yourself as the beneficiary. After your child is born, you can switch the beneficiary designation. Or, you could keep the account in your name and use it for your own education. Another option is to change the beneficiary to a family member, such as a sibling, niece or nephew.
Parents aren't the only people who can contribute to a 529 account. Grandparents and other relatives can usually contribute if they have the account number. Grandparents can also set up their own 529 accounts and name their grandchildren as beneficiaries.
Start Saving Today
As college costs continue to rise, it makes sense to do what you can to plan for expenses in advance. Contributing to a 529 plan is one way to help you manage the cost of higher education for your children, yourself or other loved ones.