Saving for College: 529 College Savings Plans

March 7, 2013

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

A 529 college savings plan is a state-sponsored program that allows parents, relatives and friends to invest for a child's (or any person's) college education. All states offer some type of 529 plan. However, in most cases you don't have to live in a particular state to take advantage of its 529 plan.

When you invest in a 529 plan, you can withdraw the money tax-free to pay for qualified education expenses—tuition, books, supplies, room and board, computer equipment and Internet service—at virtually any accredited college or university in the United States (and even some foreign schools).

A 529 account belongs to you, and your child is the beneficiary. Your money is combined with the money of other parents saving for their children's college education and invested by a fund manager hired by the state to manage the plan. Most 529 college savings plans allow you to choose from a variety of predetermined asset allocation portfolios that range from conservative to aggressive, based on historic risk and potential return.

Your plan may offer a choice between an age-based portfolio and a static portfolio. With an age-based portfolio, the fund manager adjusts the asset allocation from aggressive to conservative as your child nears college age. With a static portfolio, the asset allocation stays the same until you make a change, which you can do twice per calendar year.

What if your child's plans change? Or what if your child graduates, and there's money left over in your 529 account? You can change the beneficiary on the account to another qualified family member. Don't worry about finding a family member who needs money for college; the IRS broadly defines the term family member to include everyone from the original beneficiary’s siblings and parents to step-siblings and in-laws.

Alternatively, you can simply withdraw the money from your account. Keep in mind, though, that you'll pay federal income taxes as well as a 10% penalty for nonqualified withdrawals.

Parents, grandparents and other family members can open a 529 account on behalf of a child at a brokerage or other financial institution, or directly with a state. A child can be the beneficiary of more than one 529 plan at the same time, but you'll want to make sure the combined contributions don't exceed the contribution limit per state.

The typical initial investment to open an account ranges from $500 to $2,500. Many 529 plans allow you to open an account for less if you sign up for an automatic investing plan, with 529 contributions coming directly from your bank or brokerage account every month.

Ask whether your company allows you to make 529 contributions automatically as a payroll deduction—many companies are adding this benefit.

There's no limit to how much you can contribute each year (though there are some tax considerations—see below). Instead, there's a lifetime maximum, which varies by state and generally ranges upward of $200,000 per beneficiary.

Earnings in a 529 plan grow federally tax-deferred, which means your money has a chance to compound faster because you don't have to pay taxes on current investment income or capital gains.

Even better, withdrawals are tax-free as long as you use the money to pay for qualified education expenses, which typically include tuition, books, school supplies, and room and board (hang on to those receipts for at least six years!).

Also, if you invest in your own state's 529 plan, you may benefit from state income tax deductions on contributions or state tax exemptions on withdrawals.

Here's another tax advantage: You can contribute a lump sum of up to $70,000 to one or more 529 plans in a single year (a married couple can contribute $140,000) without incurring the gift tax—the IRS views the money as an annual $14,000 (or $28,000 for spouses) gift over five years, excluded from gift taxes. However, if you contribute more money on behalf of the same child during those five years, you trigger the gift tax.

Effect on financial aid

Financial aid formulas consider 20% of the assets held in a child's name available for college expenses. But a 529 plan is considered your asset, not your child's—only 5.6% of the money is considered available for college expenses. What's more, if the grandparents open the 529 plan, it would not factor into initial financial aid eligibility at all.

Saving for college is a smart financial move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid.

For more about financial aid, check out FinAid.org or the College Board.