For many parents, the three largest expenses they’ll ever face are retirement, a home purchase, and their children’s education. Preparing for college education expenses presents some unique challenges. So what is the best way to save for your child's college expenses?
Many parents find college savings to be particularly confusing. Additionally, college costs often occur shortly before retirement, allowing only a slim margin for recovery from poor decisions.
But saving for college doesn’t need to be confusing or difficult. In federal law, there exists a tax-favored savings plan specifically designed to benefit parents or other interested parties seeking to prepare for their loved one’s education: 529 plans.
As with many financial products, knowledge is key. Understanding the pros, cons, and strategies associated with 529 plans can make college funding straightforward and realistically possible.
529 Plan Overview
A 529 plan is one of the best ways to save for college, as it allows you to save for future education expenses in a tax-deferred vehicle. You don’t get a federal tax break upfront, but your earnings accumulate tax-deferred. If the funds are used for a beneficiary’s qualifying education expenses, then there’s no tax on the withdrawals.
There are two basic types of 529 plans: prepaid tuition plans and college savings plans.
Prepaid tuition plans allow you to save all or a portion of your beneficiary’s tuition — prepaying the future expenses at current rates. Most plans allow you to save for a future in-state public education, with limited ability to use the funds in other states.
There is also a group of private institutions that share a prepaid plan. Additionally, some institutions offer their own prepaid plans.
College savings plans are offered by states and allow you to save on a tax-favored basis. The funds can be used in any state — at most colleges in the U.S. and some outside the U.S. College savings plans have far more flexibility than prepaid tuition plans.
Fees and other costs vary from plan to plan. The typical structure is a state plan that may or may not have a state fee, using investment options provided by an investment management company, with associated costs and fees. The overall cost structure tends to be quite low. There are also plans offered through brokers, which may have additional fees.
The 529 Account Owner and Beneficiary
Anyone can open a 529 plan. Not only can you open one for your child, but you can open one for your grandchild, your spouse, or even yourself. As the person who establishes and owns the account, you are the account owner. The person who will use the funds for their education is the beneficiary. These roles are important.
As the account owner, it’s still your money. If there’s a state tax credit or deduction for the contribution, that’s yours. If for some reason the beneficiary doesn’t end up using all the funds, it remains your money. This is a significant advantage over education funding options in which the child owns the money.
Most parents are looking to save for their child’s education — not to pay for their child’s sports car. With a 529 plan, you retain control of the money.
The only reason to establish an account is to fund a beneficiary’s education. But you have options if they don’t go to school or you saved too much. You can switch to another beneficiary, allowing you to fund a different family member’s education, such as another child’s or a grandchild’s — or even your own.
Taxation and 529 Plans
Tax treatment is a primary reason to utilize a 529 plan for education. Some states allow a tax credit or deduction for plan contributions. This generally applies only when you use your own state’s 529 plan, but some states allow you to deduct contributions made to other states’ plans.
The amount of state tax deduction or credit is pretty limited and not a major incentive to participate in a 529 plan.
Assets in a 529 plan accumulate tax-deferred. You don’t pay taxes on gains made in the accounts as they grow. If used for qualifying education expenses, withdrawals are likewise tax-free. This is the major tax benefit. You grow assets for your child’s education and never pay taxes on that growth. This is a big deal. This can save you a lot of money.
If you ultimately don’t end up using the assets for education, you’ll be subject to taxation, plus a 10 percent penalty on the growth when you do take them out. That’s your trade-off. You don’t want to significantly overfund your 529 because those dollars are giving up their big advantage of favorable tax treatment.
Qualified vs. Nonqualified Education Expenses
You get to make tax-free withdrawals only for qualified education expenses. These are specifically detailed by the IRS and include tuition and fees, books, and necessary equipment and access.
You can also use 529 assets tax-free for K-12 tuition of up to $10,000 per year.
Nonqualified expenses are all expenses not specifically listed as qualified by the IRS. Examples include transportation to and from school, room and board, as well as health insurance premiums.
And if your student gets a full scholarship — good news! That’s an exception where you can still take the withdrawals and avoid taxation and penalty, except on earnings. However, the amount you may withdraw tax-free must be equal to the scholarship amount the student was awarded.
Financial Aid Considerations
This is another area 529 plans is one of the best ways to save for college relative to other funding options. Assets in a 529 plan are counted as parent’s assets when determining expected family contribution (EFC). Parents’ assets have a higher threshold where they aren’t counted. Plus, they’re counted at a much lower rate.
Having these assets counted as belonging to a parent instead of the student results in a lower EFC and potentially more financial aid.
This compares very favorably with using Universal Gifts to Minors (UGMA) or Uniform Transfers to Minors (UTMA) accounts, where the assets are in the student’s name and have a far greater impact on financial aid.
Any time you’re considering financial aid, it’s important to note that financial aid varies widely from institution to institution. While a number of schools depend heavily on the EFC, many delve deeper to determine ability to pay.
Generally, the more elite schools will do a closer financial examination, although there are exceptions. But you can’t be hurt by having a lower EFC with the same availability of assets.
The IRS hasn’t put a dollar limit on contributions to a 529 plan. Many states have contribution limits, with the average being a limit of slightly over $400,000 in total contributions.
Contributions over $15,000 per year — $30,000 for couples — put you into the gift-tax zone and is, for most people, a more practical limitation.
Circling back to the IRS: While it does not put a limit on contributions, the total amount of contributions can’t exceed what is necessary for the beneficiary’s education. This helps prevent using 529 plans for tax avoidance means other than for education needs.
This limit shouldn’t be an obstacle for most people, but you should also know it’s there. The IRS expects you to fund what you need, but not a whole bunch more.
This is a significant advantage over Coverdell ESA’s low annual contribution limits, and over the modest amount that you can shelter in a minor’s name and obtain tax advantages. There's a reason it's one of the best ways to save for college.
How Does a 529 Plan Work? Bringing It All Together
A 529 plan offers superb tax advantages, with potential state tax credit or deduction and tax-deferred growth that becomes completely tax-free if used properly for education.
It offers liberal contribution limits, with the annual gift tax exclusion being the normal barrier investors chose to stay under. It offers great flexibility, with the ability to roll over your assets to another plan or change beneficiaries as needed. Plus, it offers financial aid advantages. And it does all this with a relatively modest cost structure.
There’s not a lot to dislike about a 529 plan.
There are presently over 90 plans available. That’s a lot of homework if you’re going to compare the intricate details of each plan to find the best way to maximize your ability to save for college.
529 Plan Reviews
Comparing 529 plans is challenging due to the sheer number of great and similar plans. This review takes a look at some that have a slight edge.
California’s ScholarShare is the college savings plan of our most populous state; Florida’s 529 savings plan is the largest 529 savings plan by assets; and CollegeBacker and U-Nest are tech solutions to simplify the complex world of 529 plans.
Easiest to Use
U-Nest hands down won the ease-of-use category and scored well in the other categories, catapulting it to the front overall. You really cannot have a simpler, easier way to invest in a 529 plan. After taking just a couple of seconds to download the app, I set up an account (but short of funding) in under two minutes.
Having spent a number of years working with 529 plans, I have seen a lot of progress overall, from lengthy paper applications that took an hour or more to complete to the current state of many plans allowing online enrollment in under 15 minutes.
But I haven’t seen any other option that uses an app and allows for near-immediate enrollment without any sacrifice of features.
This is the future of investing in 529s: clean, clear, and simple. And that ease of use is here today.
2. Florida 529 Savings Plan
Biggest Bang for Your Buck
The best bang for your buck is a very low cost way to save for college, but may not be the lowest cost. Nor should the lowest cost really be the goal. After all, not investing in a 529 at all is lower cost than investing in one, but that doesn’t help get your loved one through college.
The Florida 529 Savings Plan uses in-house investment advisers and has produced solid returns at fairly low costs. The California ScholarShare actually has lower costs, but California imposes an additional distribution penalty on top of the federal penalty, making it potentially very expensive.
Best reputation was the most competitive category. The two large state plans are among the largest and are very highly rated. The two tech-based solutions have less rating information available, but their thin files are five-out-of-fives and have very favorable comments.
Best Customer Service
All four of the companies reviewed here have clearly displayed phone contact numbers and clear options to send an email, but the CollegeBacker website is the only one with a chat function. I didn’t use it, but no matter how it works, no one else seems to have one, much less have one prominently displayed.
You can’t have the best customer service without having immediate customer service. Instant chat beats waiting for an email response every time.
CollegeBacker is also very easy to use. And it has a unique pay-if-you-can approach to its service. With this method, you can commit to paying anything from zero to $10 per month.
4. California ScholarShare
California’s ScholarShare 529 didn’t emerge as the best way to save for college in any of the four categories, but it’s no slouch. The plan is easy to enroll in, and it has great investment options. The TIAA passive age-based options have to be among the lowest-cost options available anywhere.
California doesn’t offer any tax advantages on the state level. And it does have one big downside. California adds its own 2.5 percent penalty on top of the federal penalty for using funds other than for qualified education expenses. That’s a big drawback, as it's not unreasonable to think you might overfund a 529 plan and need to consider possibly using the assets elsewhere.