Find the right 529 plan

If you’re worried about how you’ll pay for your child’s higher education, consider a 529 plan. The appeal is simple: Grow your funds in a tax-advantaged account and when your child is ready for college, they can use the funds to cover a variety of education expenses.

What is a 529 plan?

A 529 plan is an account that grows your after-tax contributions. The beneficiary can later withdraw the funds from this account tax-free to pay for qualifying educational expenses.

Types of 529 plans

There are two primary types of 529 plans:

All 50 states and the District of Columbia offer 529 plans. Most individuals elect to open a state-sponsored 529 college savings plan. With most state-run plans your investments may fluctuate in value, and you’ll pay tuition when your child starts college.

Prepaid tuition plans, such as Private College 529 plans, are promoted by more than 250 private colleges. These plans let you pay for tuition in advance to lock in current rates.

Benefits of 529 plans

A 529 plan can offer multiple benefits for educational expenses and your pocketbook, including:

• Covering eligible expenses at qualifying colleges. Start saving early and you’ll be financially prepared by the time your child goes to college.
• Using funds for K-12 tuition. Withdraw up to $10,000 a year tax-free to pay for tuition at public, private or religious schools.
• No federal tax on earnings. While you can’t deduct your contributions on your taxes, your earnings will grow without being dinged by federal taxes. The funds you withdraw for qualifying college expenses also won’t be taxed.
• Additional tax benefits. Many states offer tax deductions or tax credits for your 529 plan.

529 college savings plan tax benefits by state

See if your state offers tax deductions and credits.

529 prepaid tuition plans

Prepaid tuition plans may be an option to protect yourself from rising tuition in the future. See which states currently offer prepaid tuition plans.

Many states have closed their plans to new enrollment. Virginia’s Prepaid529 plan closed for new enrollment in May 2019. But administrators say a similar program is in the works. Illinois’ prepaid plan is seeking funding from the state legislature, and enrollment is currently on hold.

Before enrolling in a prepaid plan, consider whether it’s guaranteed by your state. If it’s not, you may later find your payments are insufficient to cover tuition.

Risks of 529 plans

529 plans provide multiple benefits. But you’ll want to watch out for potential pitfalls to protect your money, including:

• Penalties for non-education expenses. You’ll pay taxes on your earnings — along with an additional 10% penalty — if you take out a nonqualified distribution.
• Less flexibility. Unlike a savings account, it’s disadvantageous to move funds out of a 529 plan given the withdrawal penalties and taxes you’ll incur.
• Fees for taking out too much money. If you take out funds beyond those required for qualified education expenses, you’ll incur a tax burden and 10% penalty on the excess amount.
• Having too much money in your 529 plan. You’ll take on tax and penalty fees if you have any leftover funds in your account and no qualifying expenses for them.

Fees to watch out for

Look for a plan with low fees, so your contributions can grow as quickly as possible. Here are major fees to consider:

• Management and administration fees. An outside firm will typically manage your 529 plan. This means that the firm and state agency who administers your plan will likely take a cut ranging from 0.10% to 0.70%.
• Investment fees. Mutual funds are very common in 529 plans and they typically have expense ratios below 0.15%.
• Charges for buying through an advisor. You may pay a commission to your advisor as high as 5% to 6% for their guidance.
• Account maintenance fees. Your plan may charge a yearly maintenance fee ranging from $10 to $25. You might have this cost waived if you meet requirements such as living in the state that issues your 529 plan or making automatic contributions.

Adviser-sold vs. direct-sold 529 plans

When you’re ready to open a 529 college savings plan, consider whether you want to work with a financial adviser or directly through a 529 provider.

Adviser-sold 529 plans

A financial advisor will provide guidance and help you stay on track with funding your 529 plan. Your advisor may also assemble a unique mix of investments that you wouldn’t find with a direct-sold 529 plan.

But you’re likely to pay higher fees than you would with a direct-sold plan. Your adviser will charge you a commission and they may put your money into actively managed funds that come with higher fees, rather than passively manage your funds.

Direct-sold 529 plans

With direct-sold 529 plans, you’ll likely pay lower fees. It’s also easy to open one online without the help of an advisor.

Unlike advisor-sold 529 plans, a direct-sold plan requires you to pick your own investments. If you don’t want to spend time choosing your investments, see if your chosen 529 plan offers age-based portfolios.

How to open a 529 college savings plan

Open a 529 college savings plan in five steps:

1. Decide on a 529 plan. Research your state’s 529 plan as well as plans from other states. Consider your state’s tax deductions or credits and whether you want an adviser-sold or direct-sold plan.
2. Choose between an individual and custodial account. An individual account has a parent or grandparent as the account owner, who keeps control of the 529 plan. With a custodial account, the child is both the beneficiary and the account owner. The adult custodian will direct the account until the child becomes an adult.
3. Complete the application. You’ll need to provide the account owner’s and beneficiary’s Social Security number, address and contact information. If necessary, name a successor account owner in the event of the original owner’s death.
4. Select investments. You can often choose between actively and passively managed funds.
5. Fund your 529 plan. Fund your plan with a check, electronic bank transfer and automatic contributions from your bank. Other funding methods may include payroll deduction or a rollover from an existing 529 plan.

What can a 529 plan pay for?

Your beneficiary can make withdrawals tax- and penalty-free for qualified expenses, which are required costs for college enrollment or attendance. But be careful: Many reasonable-sounding expenses don’t qualify.

Below you’ll find a few common qualified and nonqualified expenses.

What do I do if there’s money left over in my 529 plan?

You can take a non-qualified withdrawal and incur taxes and a penalty.

Or you can change the beneficiary to a cousin, daughter-in-law or even yourself. As long as the beneficiary is an eligible family member, they won’t pay taxes or a penalty.

Another option is to leave the 529 plan as is, since your child may later decide to attend graduate school.

Other college savings accounts

Before deciding on a 529 plan, you may want to consider other college-funding options, including:

• Coverdell education savings account. This is similar to a 529 plan, except you can use it for a wider variety of K-12 expenses, such as books, supplies and tutoring.
• Roth IRA. A Roth IRA is a retirement account that grows your contributions tax-free. Normally, you’ll incur taxes and a 10% penalty if you withdraw earnings before you turn 59 and a half. But there’s no penalty when you make withdrawals for qualifying education costs, though you’ll still pay income taxes.
• High-interest savings account or CD. A high-interest savings account can give you the flexibility to withdraw funds when you need them. You can earn higher interest with a CD, but your money is locked away for a specific time period.

How to compare college savings accounts

• Decide what you intend to use funds for

  Plan out your child’s educational path, and see if a certain account lets you fund that vision with minimal taxes and penalties.

• Return

  Think about the returns you might earn with certain accounts. Consider your confidence in your money manager’s — or even your own — investment skill.

• Availability of funds

  Taxes and penalties are designed to keep you from withdrawing money on a whim. If you need easier access to your money, consider savings accounts or CDs, which offer more windows for withdrawals.

• Fees

  Consider fees at every turn — including setup fees, maintenance fees, expense ratios and commissions. These costs ultimately eat into your returns.

Bottom line

529 plans are a great way to prepare for your child’s college education, especially as contributions grow tax-free.

But if you’re not comfortable putting your college savings at risk, consider savings accounts and other potentially lucrative options.