Year after year, the cost of higher education continues to climb, and many parents face the troubling prospect that expenses could increase significantly more by the time their kids get to college. Investing in a 529 college-savings plan offers tax and financial aid benefits, and it gives your savings the opportunity to grow in the stock market.
A 529 plan is a state-sponsored college education savings account. Withdrawals are tax-free as long as the money is used for qualified educational expenses, which include tuition and fees, books, supplies, and room and board. In addition, two-thirds of states offer an income tax break for contributions to the state’s 529 plan.
Another benefit is that 529s are treated favorably for purposes of financial aid. When a prospective student applies to college, assets that the student owns are usually weighed more heavily than the parent’s assets when determining eligibility for financial aid. However, if the prospective student is a 529 beneficiary or is the owner of a 529 account, assets in the plan are treated as a parent asset, which helps to maximize aid, says Mark Kantrowitz, author of How to Appeal for More College Financial Aid.
Generally, you can invest in any state’s 529 plan regardless of where you live, although a handful of states limit their plans to residents. Investing in your own state’s plan may provide a tax break, but you should also pay attention to fees and investment options when choosing a plan.
To get the most benefit from tax-free growth, you should start investing in a plan as soon as possible. If you make a monthly contribution of $200 for 18 years, for example, with an average gain of 7% a year, you’ll have about $84,000 when the child is ready to enroll in college. You can crunch the numbers yourself with the Bankrate simple savings calculator.
When you invest the funds in your 529, you’ll generally have a choice between a dynamic plan or a static plan. A static 529 plan invests all of your contributions in index funds or a similar portfolio, while a dynamic portfolio — also known as an age-based plan — adjusts the asset allocation each year, becoming progressively more conservative as the first year of college approaches. The age-based allocation typically offers a range of investment strategies, from low risk to aggressive.
Using your 529 funds
If you withdraw money from a 529 plan for nonqualified purposes, you’ll pay federal income taxes and a 10% penalty on the earnings. However, if it turns out your child doesn’t need all of the money — because he or she decides not to attend college, for example — you can transfer the plan to another relative or name yourself as the beneficiary if you’re interested in pursuing a college degree.
You may also be able to roll unused 529 funds into the beneficiary’s Roth IRA. To qualify for a rollover, the 529 must have been open for 15 years or more, and the amount you can roll over each year is limited to the standard IRA maximum contribution ($7,000 in 2024 for those younger than 50).
There’s also a lifetime cap for Roth IRA rollovers of $35,000 per beneficiary. In addition, the amount you roll over must have been in the account for at least five years, says Mary Morris, CEO of Virginia529. There are also restrictions on the timing of withdrawals. “So even if you’ve had the account for 15 years, you can’t dump a bunch of money in and the next week or the next month move it into a Roth,” she says.
Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
