College savings plans: Everything you need to know

You may have heard that 529 plans are a great way to save for a child’s college education ahead of time, but what are they and how do they really work? Named after Section 529 of the Internal Revenue Code, 529 plans offer families an college savings strategy with significant tax benefits.

Two types of college savings plans

Although 529 plans are named for the federal tax code, they’re actually run by individual states. Investment options, potential returns, tax advantages, fees, and rules vary by state. You don’t have to enroll in the plan administered by your state. Families can enroll in another state’s plan and receive many of the same tax advantages.

Most states have two types of plans:

1. A prepaid tuition plan (or a prepaid 529 plan) allows you to lock in your child’s tuition at cheaper cost. You’ll pay a set price now that is lower than what tuition will cost when your child attends college. These plans are only offered in about 18 states and many have residency requirements, meaning you must live in the state to participate in the plan.
2. A college savings plan lets you invest your money after-tax, much like a Roth IRA. The plan may gain or lose value with the market but your money grows tax-free and no taxes are due when the money is withdrawn. Additionally, many states offer tax breaks on the contributions you make each year.

The best part of both plans is that friends and family members can also contribute to a child’s 529 plan, subject to some dollar limits.

What education costs does a 529 plan cover?

A 529 education savings plan offers tax-free earnings growth and tax-free withdrawals when the funds are used to pay for specific educational expenses, like books and tuition. Generally, proceeds can also be used to cover room and board, though there are some restrictions for things like off-campus housing.

Some expenses, such as student health insurance, are not covered, unless the college charges them as part of a comprehensive tuition fee or the fee is identified as "required for enrollment or attendance" at the institution.

• Education savings plan assets can also be used to cover:
• Up to $10,000 per year to pay for K-12 private school tuition.
• College and graduate programs.
• Student loans with a lifetime cap of $10,000 per borrower.

Which college savings plan should I choose?

If you’re sure the student will attend an in-state college or university, a prepaid tuition plan offers peace of mind. All qualified educational expenses at any in-state higher education facility will probably be covered. (The plan structures vary by state, so be sure to confirm the details.) And if your student chooses an out-of-state school, your prepaid 529 plan will pay you a set amount based on your contributions. Be aware that if the out-of-state school costs more, you or the student will have to make up the difference.

With a typical 529 college savings plan, you choose how much to contribute and when. You also can choose where you invest, though the selection is usually quite limited. You have more control than a prepaid 529 plan, but you also take on more risk - for example, your student’s tuition is not guaranteed to be pre-paid.

Am I limited to my state's plan?

Families can invest in the college savings plan of any state, not just their own. The investment offerings and fees vary widely among states, which means other states may have plans with lower fees and better potential returns.

Two things to know:

First, although many states have plans administered by well-known companies, such as Vanguard and T. Rowe Price, it’s usually better to invest through a state than directly through the fund manager.

Second, many states offer state tax breaks to their own state’s residents. If yours does, and you plan to invest in an out-of-state plan, make sure you understand the tax consequences.

The drawbacks of each type of 529 plan

The drawbacks of prepaid tuition plans are fairly obvious:

• You have no idea if your child will attend an in-state school
• Investment returns may be lower than you could achieve in a college savings plan
• Qualified expenses are often limited to fees and tuition

College savings plans also have some downsides:

• Investments are subject to the same risks as non-education accounts, including market volatility and potential losses
• In many cases, there are significant penalties if money from 529 plans are used for non-education expenses
• Investment options are often limited

What if we don’t need the money later?

If your child doesn’t go to college or a qualified technical school, what happens to the money in their 529 plan? Or what if they get scholarships and need little or no money from their 529 account?

You have several options.

First, the money in a 529 is portable. You can transfer the money to another child or family member with no adverse tax consequences.

Second, if your child gets a scholarship and doesn’t need the money, you can take out the amount of the scholarship annually and use it for non-education purposes. You’ll pay taxes on the proceeds, but there are no additional penalties.

Third, you can withdraw the money and use it for a non-education purpose. You’ll pay taxes on the proceeds, plus a 10% tax penalty. However, legally you can only use money from a 529 account for the child’s benefit, not your own. The penalty is waived if:

• The beneficiary receives a tax-free scholarship
• The beneficiary attends a U.S. Military Academy
• The beneficiary dies or becomes disabled

Finally, there’s no time limit for using the money.