529 College Savings Plans Guide

1. What is a 529 Plan?
Congrats! We give you kudos for opening up this guide. Doing so means you're thinking about saving for college- not just paying for it. And the scary nomenclature 529 didn't scare you off.

There's only one great way to save for college: with a 529 plan. This plan, named for the section of the Internal Revenue Code that created it, is a type of investment account.

Why are 529 plans so great? Well, it all has to do with taxes. With 529s. you have to pay normal income tax on the money you put into your plan. But you don't pay taxes on the investments' earnings once they're parked in the account, or when you take them out to pay for college. This is always the case, as long as you use the proceeds for tuition, room, board, or other college-related expenses.

This is a tax break worth thousands of dollars if you start early and save a lot over time. It's also one of the few lucrative tax incentives for savers that don't disappear if your income gets too high (the way it does with a Roth IRA, for instance).

Thanks to the odd way in which these accounts came into existence, which we won't get into here, you don't just set up a 529 plan the way you would, say, an IRA. Almost every state has a different 529 plan, and many have a handful of them. Each state picks a single administrator, like Vanguard, to run its plan and handle accounts for investors. These investment managers become, in effect, the brokerage firm for your college savings money. If you want to invest with the plan in your state, you have to work through the state's administrator. You don't have to invest in your state's plan, however - you can invest in any state plan.

There are two main kinds of 529 plans:

  • Prepaid Plans: With prepaid plans, you pay for a year (or a portion of a year) of tuition ahead of time, effectively locking in the price. You may be able to pay today's tuition rate, or some states require a bit more to be paid for this privilege. But then you've effectively locked in tuition for your kid's school at any point in the future - no matter how much tuition has risen by the time your kid enrolls.
  • Investment Plans: The prepaid plan may sound enticing, but we think an investment plan is the better choice - especially for parents with younger children. With investment plans, you choose how you want to invest your funds and then you can use that money (and the earnings it made) for a variety of educational costs at a variety of institutions.

You can raid your 529 funds for non-educational needs if you get into a tight spot. But it will cost you. You pay ordinary income tax rates on the gains, plus a 10% penalty to the government. There are some exceptions. If your kid wins a scholarship, becomes disabled, or dies, you can take the money out without penalty.

2. Should You Invest in a 529?
Saving for a college education years ahead of time sounds insane, right?

Many of us have big debts from college or graduate school and are scrimping to make ends meet. Toss in a mortgage, car, or credit-card debt and the idea of finding another $100 a month to put away for college seems absurd.

But it isn't. As with retirement, the best time to save for college is when you have the most time for the money to grow. If you wait until later to save for college, you'll be passing up the incredible tax break that 529 plans offer. Because you pay no taxes on earnings as long as they're used for college expenses, the sooner you start saving, the more tax-free earnings you'll have as the account grows.

We're not saying you should put money into a 529 Plan instead of funding a retirement fund. You should definitely save for retirement now, and don't save a cent for college until you've taken full advantage of any matching contributions your employer offers into your 401k or similar account.

Feel like all of this will eat into your family budget? The best thing you can do is sacrifice a little while your kids are very young in order to sock some money away for both retirement and college savings. Then take a decade off from college savings if you must and start saving again once your children are in high school. That way, your early savings benefit from 15 or 20 years of returns, with each year's gains growing on top of last year's and the years' before that.

Concerned that you'll miss out on financial aid if you start saving now? You shouldn't. The federal formula for calculating aid eligibility only expects parents to use 5.64% of 529 balances each year to pay college expenses. So there's not a huge financial-aid penalty for saving money. Plus, financial aid packages have a lot to do with your income, and nobody can say for sure what their income will be 10 or 20 years from now.

There can be a massive penalty, however, for assuming financial aid will take care of things 15 or 20 years from now. By then, you may make too much money to qualify. And let's be real - most aid is in loans anyhow. So by blowing off saving, you're either committing to borrowing massive amounts yourself when your kids are in school or saddling the kids with the debt (or both, most likely).

Worried that you'll sock too much away? Well, it's pretty much impossible to over-save in a 529 account. You can use extra monies to pay for graduate school. You're also allowed to change the beneficiary of a 529, usually at least once each year. So you could use leftover money from your first born for a second child, or let it ride another 30 years for your grandchildren.

You can even use a 529 plan for yourself. How about taking an art class…in Rome…when you retire?

3. Advice on Choosing a Plan
OK so you know you need to start saving for college now. Let's try to radically simplify the process of picking a 529 plan. You can choose a plan in just three steps that will take you less than five minutes. After you pick your plan, enrolling might take a half hour or so.

1. First, check out the 529 plan in your state. More than half of states offer a state income-tax deduction or income-tax credit on residents' contributions to their state's own plans. This is the chief benefit of having so many plans to choose from - your state might offer an incentive to keep your money at home. The directory at savingforcollege.com is the best place to look up the specifics of your state's plan and any incentives it may offer. If your state offers a tax break, it's usually worth saving in your state's plan in order to max out the tax deal. You remain free, however, to invest in any state plan. If your state doesn't offer a tax break, there's little benefit in choosing to stick with your own state's plan.

2. Once you've chosen a state, you'll have to pick between an investment plan and a prepaid plan.

  • Prepaid Plans: As we mentioned in Section I, with these plans you pay for a year (or a portion of a year) of tuition ahead of time, effectively locking in the price.

The prepaid plan may sound enticing, but we think an investment plan is the better choice - especially for parents with younger children. One big problem with prepaid plans is that they generally only work for in-state, public universities.

If your kid ends up going someplace else, you can still get the money out. The problem is that the money you invested in the prepaid plan won't have grown at anywhere near the rate it likely would have, had you put it in stock mutual funds in the investment plan. A prepaid plan grows at maybe a couple of percentage points a year - less than half of what a good collection of mutual funds would get over the same period. And really, how can you possibly know where your kid is going to want to go to school 10 or 20 years from now?

There is a way to prepay for private colleges, but it isn't exactly the best of both worlds. It's called the Independent 529 plan and it allows you to buy discounted chunks of private school tuition, years or decades ahead of when the account beneficiary will go to school. The problem is that not every private school in the country participates.

Prepaid plans make sense in one scenario: Let's say your kids are in their teens, and all they've ever wanted to do is go to one of the great state universities nearby (or to a private school that participates in an Independent 529). Once you know that that's what they want, then that's the time to buy in, at today's discounted rates. Then, you don't have to worry about investment returns for, say, the next five or seven or nine years.

  • Investment Plans: You're in charge of your own investing fate with these funds. Start early, and get your asset allocation right, and your savings will grow into a healthy college fund.

If you decide to go this route, look for a state where the total program fees and fees for the mutual funds are lower than 0.75%. Fees can really eat into your returns and, if you start investing early, fees can really pile up. Again, you can search by state on savingforcollege.com to look up the fees.

Can't be bothered to shop? Just use the Utah plan. We're big fans of it, since fees are less than one half of one percentage point and Vanguard, a company that is generally very consumer-friendly, runs many of the mutual funds.

3. Once you're in an investment account, you have to decide how to divide your money between stocks and bonds. One easy way: Invest in an age-based fund, which an increasing number of states offer. These funds may also be referred to as target-matriculation date funds. These funds create an investment mix of stocks, bonds, and other assets based on the date when your child will start college. The manager of the fund changes the mix so it gets more conservative as your kid gets close to college age. The advantage here is that you never have to tweak the mix yourself. We say a bit more about target date funds in our mutual fund guide.

OK - you've already done the hard work. Now here are three easy (and free!) ways to save some more:

1. Enlist the help of grandparents and other relatives.
In some states, they can contribute to the account you set up. In other states, they have to set up their own and name a child as a beneficiary (two siblings can't share the same account).

2. Enroll in Upromise.
Upromise is a loyalty program: if you agree to shop online through its site (it redirects you to hundreds of other name-brand sites like Target and iTunes), you get a percentage of your purchase refunded. Then, you can move those refunds to a 529 plan (any plan you want, though it can be a bit easier if you're in a 529 affiliated with Upromise ). You can also earn refunds based on where you eat out and what you buy at the grocery store. This costs nothing, and we can't understand why every single person in the U.S. who has a child or grandchild isn't enrolled.

3. Divert credit-card rewards into the 529 plan.
Citibank has a card with Upromise, and American Express offers an especially lucrative card that puts 1.5% of every purchase into a Fidelity 529 (you have your choice of a few state plans, since Fidelity manages a handful of them on behalf of various states). True, frequent-flier miles offer more immediate gratification for credit-card shoppers. But those miles don't earn returns the way money in a 529 fund would.

Honestly, just getting some money in a decent index fund or target-date fund before your kids start nursery school is our definition of success. Get started, get it mostly right, and focus in on the smaller details as your kids get older and the balances get bigger.

4. Grilling Guide: Questions to Ask When Choosing a 529 Plan
Do I get a state income-tax deduction or credit for investing in my home state?

More than half the states do this. In states with high income tax rates, this can put several hundred dollars or more back in your pocket each year.

What are the fees the plan charges?
There may be program fees in addition to any fees that the mutual funds levy. Ask about each and every fee that you might pay.

As we explain in the mutual fund guide , we're big believers in index investing. If a fund doesn't offer at least one stock and bond index fund, complain to the investment managers - or skip the fund altogether if you don't have to use it to get your state's income-tax deduction. Same thing goes for target-date funds.

Can I close the account and move my money to another state's 529 without any penalty, like having to return tax deductions from previous years?
Only a few states allow this, but ask anyway. You might want to do this if you move of you find a much better deal.

If you're using a broker, ask them what about the commission s/he makes.
Most states have a separate class of 529 plans that kicks some money to the broker for steering you to their plan. So there might be at least three 529s in a state: an investment plan for people investing on their own, another one that pays commission to brokers but offers the same investment choices, and then a prepaid plan.

If a broker's involved, you might invest $5,000 and then the broker could get, say, 3% - that's $150. That doesn't come out of your funds; you still will see a balance of $5,000. The more people invest this way, though, the higher the costs are for the state to run the plan. And that gets reflected in fees, which investors ultimately pay.

Brokers have gotten in trouble in the past for steering clients into out-of-state 529 plans simply because those plans paid the highest commissions (or the underlying funds were managed by the broker's company). It's not obnoxious of you to ask brokers or advisers what sort of commission they're earning. It's only obnoxious if they won't tell you the answer.

A financial planner who pledges to only earn money from client fees - say, an hourly payment or 1% of a client's assets - rather than from commissions will steer you into a 529 plan like the one you'd buy on your own.

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