Section 529 Plans

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For parents interested in setting aside money towards college expenses for their children, a Section 529 account is one of the best ways to do so. A Section 529 plan offers an opportunity to invest money for your child's college tuition tax free. A Section 529 plan also offers the alternative of prepaying your child's tuition at today's prices, rather than the higher costs you can expect when your child is ready to enroll. It's also easier to open a Section 529 account than many other college savings accounts.

529 Prepaid Tuition Accounts

The most important decision when it comes to choosing a Section 529 plan is whether you'd prefer to prepay tuition or to simply save money towards education expenses. That's because there's actually two different types of Section 529 plans.

The option of prepaid tuition plans can provide an extra benefit if your child won't be attending college in the near future: because the inflation of college expenses is growing faster than inflation for normal expenses and the cost of college is expected to continue to increase, paying tuition at today's rates can translate into significant savings.

Section 529 plans are offered by individual states, and the exact options for each state can vary. In many cases, you can choose a Section 529 plan from outside your state of residence, although the benefits may not be the same if you're outside the state operating the plan.

529 Savings Accounts

The alternative to a prepaid tuition plan is to contribute money to a Section 529 account and then invest it through the account. Depending on the investment options associated with your state's plans, you may be able to earn a return on your money that more than matches the savings offered by prepaying tuition.

There are some limits to the investment options available to you with a Section 529 account. Where some investment accounts may have a wide variety of investment options, many Section 529 plans are limited to specific mutual funds. In most cases, the state operating the Section 529 plan will actually turn over management of it to a mutual fund company. The funds available to that company are typically the only funds you'll be able to choose from.

Most Section 529 savings plans offer investment option based on your child's age. As your child gets older, the investments become more conservative, in order to be sure that the money you need will be available when your son or daughter is ready for college.

529 Tax Benefits

When you deposit money into a Section 529 account, you'll be using after tax dollars. You've already paid taxes on that money just by paying your yearly income tax. The money in your Section 529 account grows tax-deferred and, assuming that you only withdraw the money in order to pay for educational expenses, you won't be required to pay taxes on your earnings. These advantages make it possible to maximize the return on the money you've saved for your child's education. Normally, any money you earned from an investment would be taxable the moment you withdraw it, but you get to keep the money that would otherwise go to taxes and apply it to your son or daughter's education.

Many states also offer deductions on your state tax return for any money you saved in a Section 529 account. Typically, the deduction is limited to parents who invest in an instate Section 529 plan. You may not be eligible for the deduction if you use an out-of-state plan, often making the in-state option the best option just because of the tax deduction.

The Pros and Cons

There are other savings options for parents who want to put away money towards their child's education expenses, such as a Coverdell Education Savings Account. While such accounts do have some benefits to recommend them, in many cases, a Section 529 plan has many advantages. One of the most important factors is the amount of money you can put away in each account. With a Coverdell ESA, you face a limit of $2,000 per year. Unless Congress renews legislation affecting the Coverdell ESA, that limit may drop to $500 per year. A Section 529 savings account does have an upper limit on the amount that you can contribute per recipient: depending on that state, the lifetime limit ranges from $100,000 to $300,000.

Unfortunately, one advantage of a Coverdell ESA is not available to parents using Section 529 accounts. Money saved through a Section 529 plan can only be used towards college or graduate school expenses. Some other accounts, such as the Coverdell ESA, allow parents to withdraw funds to use for pre-college expenses, such as tuition at a private elementary or high school.

Most colleges will take the amount available in your son or daughter's Section 529 account when calculating his or her financial aid package. The account can reduce the total number of financial aid; however, colleges similarly account for other college savings accounts. The Section 529 plan does have the benefit of usually being listed as a parental asset, rather than an asset of the student applying for financial aid. Some college savings accounts are considered student assets and can reduce your child's available financial aid far more than an account listed as a parental asset. Some state colleges will also leave money saved in an in-state Section 529 plan out of their financial aid calculations, essentially offering your child a larger financial aid package.

Setting Up a 529 Account

No matter whether you choose a Section 529 savings account or a prepaid tuition plan for your child, the logistics of creating the account are similar. You can open the account and name a beneficiary — your child, typically, although you can name other beneficiaries — who will be able to use the money in the account once he or she is ready for college. The Section 529 account does not have to be opened by a parent. Not only can other relatives open the account, but so can individuals who aren't related to the beneficiary.

Similarly, anyone can contribute to a Section 529 savings plan. For instance, if your child's grandparents wanted to save money towards your son or daughter's college expenses, they could easily do so. However, particularly large deposits (over $12,000), from you or anyone else, can trigger a gift tax. There is a special provision for Section 529 plans, allowing an individual to make five years worth of deposits in one year, totaling up to $60,000.

You can set up direct deposit to automatically add money to a Section 529 plan in most states. This approach can make it very easy to continue saving money towards your child's education without having to plan to transfer money or take other steps. There is no deadline for contributing to a Section 529 account.

Eligible Expenses

Once your son or daughter heads off to college, you can request a distribution from a Section 529 savings plan on behalf of your child. In order to avoid taxes or penalties, the disbursed money must be used for qualified educational expenses, as defined by the IRS. Those expenses are limited to tuition, room and board, books and supplies required by your courses and computers or laptops (but only if the college requires them). Your child must also be enrolled at least half-time in order to use funds from your Section 529 account for room and board.

If you choose to withdraw money from a Section 529 savings plan for purposes other than educational expenses, that withdrawal will be subject to taxes and a 10 percent penalty. If, after your child has completed college, there is money left in the account, it can be transferred to a new beneficiary.