How to Open a 529 College Endowment Plan for Your Child
As you probably guessed, college is expensive: if you want your child to go to university or vocational school, the sooner you start saving for it, the better. To do this, you need to consider saving on the education investment known as the 529 plan.
How the 529 plan works
Named after the IRS code they fall under, the 529 savings plans are for tuition and other education expenses in any primary, secondary, religious, vocational, or other postsecondary institution (as well as some schools overseas). As with other types of long-term investment accounts, you save money and watch it grow with compound interest until you are ready to withdraw it (you must be 18 or older to invest in this plan).
The main benefit of the 529 plan is that while contributions are taxed upfront, profits will grow excluding taxes over time, similar to the Roth IRA . Another big advantage is that withdrawals for qualified educational expenses (e.g. tuition, class laptops, student housing) will not be subject to federal tax, and in many cases they are also not subject to state tax. You can view your state’s withholding policy here . The total potential income tax savings in some cases can be approximately 30% of the withdrawal amount, depending on the state in which you live.
Unlike other types of investment accounts, these plans are government funded, which means your plan options may vary depending on the state in which you open the account. Some states also offer a variety of plans to choose from, which you can find by state here . (If you want to avoid the hassle, you can also work with a financial advisor to select a plan for a fee.)
There are two types of plans
There are two main types of 529 plans: prepaid plans and investment plans (states are allowed to offer both, but some don’t ).
With a prepaid plan, you pay for a year of study or course unit in advance and lock in the rate. You pay mostly now to avoid future increases in costs. The downside is that these plans may be limited to schools that are in the state.
With an investment plan, you choose how to invest the money saved. You will still have to use it to cover education costs, but you are not tied to specific tuition fees or college units as if you were with a prepaid plan. For this reason, most experts advise sticking to an investment plan.
Most 529 investment plans have options for age or individual plans. With a personalized plan, you choose how to split or adjust your portfolio as you see fit. With an age plan, the composition of your portfolio is automatically adjusted as the recipient approaches college age. These plans start with a high percentage of equity investments (eg 80-100% equity investments) and then move to a lower percentage over time (eg 10-20%). The idea is to maximize early growth and then minimize exposure as we move towards expected withdrawal.
How to open plan 529
Before you open your 529 plan, decide on the state. The state sponsoring your plan also does not require the school to be located in the state (although prepaid plans may be an exception to this rule), so students can use the money to attend a qualifying school elsewhere.
- Use this tool to find and compare your state’s plans with those of other states, including fees and investment options. Vanguard also has a government tax calculator that can tell you exactly how much your potential tax benefit is worth.
- Before choosing a plan, please read their program disclosure statement to make sure you are familiar with all of the terms and conditions. In other words, read the fine print so you know what you are getting yourself into.
- When registering, you need to specify the account owner (also known as “member”), which you are likely to be. Not many 529 plans allow cross-ownership, but relatives and non-relatives can always donate to 529.
- You will also need to name the beneficiary: the person receiving the college money (presumably your child). Keep in mind that it is the owner, not the recipient, who controls the assets at 529. From there, you can usually link your checking or savings account to your 529 account to make regular automatic contributions.
Other rules you should know about
- Unlike other tax-exempt accounts, 529 plans do not have specific contribution limits set by the IRS. However, most states have limits of $ 350,000 to $ 500,000 on Nerdwallet .
- Perhaps more notable are the implications of the gift tax: As the IRS explains, if your annual contribution to the 529 plan (along with any other gifts) exceeds $ 15,000, you might have to pay gift tax. (However, there is a way around this with a process known as superfunding .)
- Plus, it’s pretty easy to change recipients in your 529 plan. If your child is receiving a scholarship and does not need all the money you have invested over the years, you can easily change the recipient to a brother or sister.
- The 529 plan is a great way to cover skyrocketing education costs, but make sure you spend the money on matching education expenses or your withdrawal will be subject to income tax along with an additional 10% tax penalty.
This post was originally published in 2017 and was updated on December 30, 2020 to reflect changes to 529 plans, update links, and align with Lifehacker style guidelines.