The ABCs of 529 plans

One of the most common financial goals after retirement is paying for a child’s education. And just as with retirement savings, there are ways of saving for college that can also help you save on taxes.

The most popular of these is the 529 college savings plan which, like the 401(k), is named for its section in the U.S. tax code.

To learn the ins and outs of 529 plans we turned to a Vanguard crew member—we’ll call her “The Young Investor”—who specializes in educating parents and children about saving for college and is using one to benefit a young relative.

Question: What is a 529 plan?

The Young Investor: It’s a plan to aid and encourage saving for higher education by providing some tax benefits to the person, say a parent or grandparent, opening an account.

Many states allow taxpayers to deduct their 529 contributions up to a certain dollar amount. And later on, if you spend the money on qualifying educational expenses, you won’t owe taxes on withdrawals of contributions or earnings from a 529 plan.

These two tax advantages can help your college dollars stretch farther.

Question: There are many 529 plans available, right? How and why do you choose a specific one?

The Young Investor: It’s important to do your research before choosing a plan.

First, check with the plan sponsored by your state. You may get specific tax advantages based on where you live. Some states give you a tax break even if you invest in another state’s plan. Other states do not offer tax advantages.

Take a look at each plan and consider factors such as tax advantages, investment options, and fees.

Question: When should you start saving?

The Young Investor: It’s never too early to save! You can even save for children before they are born.

Question: Does it make sense to start a plan if a child is already in high school?

The Young Investor: It’s never too late to save. Even if the child is in 11th grade, every dollar saved is a dollar you or the student doesn’t have to borrow.

Furthermore, you can even enjoy the tax benefits of contributing to a plan while the child is attending college. It may be a great benefit to continue to contribute to your 529 after your child begins college.

Question: Can you automate your contributions to a 529, much like you automate contributions to a retirement plan?

The Young Investor: Absolutely! Automatic contributions are a great way to contribute to a 529. You can set up recurring payments according to your specifications.

Of course, this doesn’t mean that you can’t contribute on special occasions, such as birthdays and holidays. You can make a contribution at any time, typically electronically or by check.

Question: How are contributions invested by the plans? Can you choose the fund or funds in which to invest?

The Young Investor: Many plans offer a wide assortment of mutual funds.

Plans may also offer an age-based fund. You pick the year in which you expect the child to attend college. Early on, the fund will be aggressive and invested primarily in stocks. But as the child gets closer to entering college, the fund grows increasingly conservative, moving money from stocks to bonds.

Question: Is there a limit to how much you can contribute to a 529?

The Young Investor: Each state sets its own limit. It may range from $200,000 to $400,000.

Question: Can the money be used only for colleges or universities?

The Young Investor: According to the IRS, you can use the money for any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program run by the U.S. Department of Education.

Question: What kinds of expenses can the 529 be used for?

The Young Investor: You can use the 529 money for tuition, room and board, fees, books, and other expenses at a variety of eligible schools, including colleges, universities, and trade or technical schools.

Recent updates to 529 regulations now allow you to use some of the money to buy a computer, even if college doesn’t require you to have one.

Question: Does it matter where the child chooses to study?

The Young Investor: It is a common myth that children must go to school in the state that sponsors the plan. Some states may offer prepaid plans for that specific state, but the majority of plans may be used in any state, and even some institutions abroad. The institution must be approved by the Department of Education.

Question: Is there a deadline for using the money?

The Young Investor: No. It can be used for graduate school or other future educational expense. It may also be transferred to a relative as a new beneficiary.

Question: Can the savings in a 529 diminish a child’s ability to get additional financial aid?

The Young Investor: As long as you, as the parent, are the account owner and you claim your child as a dependent, the savings in a 529 will have a much lower impact on financial aid than any different type of account opened in your child’s name.

Financial aid policies differ widely among schools, and all your assets—including 529 plan accounts, bank accounts, and other holdings—will most likely be assessed as part of the child’s qualifications for aid.

However, as long as your 529 account is considered to be your asset and not the child’s, it will have a relatively minor impact on financial aid.

The child’s eligibility for federal financial aid will be reduced by no more than 5.64% of your 529 savings.

Question: So what happens if the child for whom you funded a 529 doesn’t go on beyond high school?

The Young Investor: As a parent, you can use the money for your own education. Or you can transfer the account to a new beneficiary who is a close relative, typically up to a first cousin.

Question: What are the tax implications if the money is used to pay for something other than an educational expense?

The Young Investor: Penalties on earnings, not your contributions, apply when you use the money for costs that aren’t for qualified expenses.

Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes.

If you received a tax deduction on your contributions, your state might require you to pay it back if you use the money for expenses that aren’t qualified. Some states also adjust the amount owed for inflation.

Question: What else do I need to know about 529s, and where can I get more information about them?

The Young Investor: I think the most important things to remember are that it’s great to save early, but it’s never too late to start.

You’ll need to do some research to determine the best plan for your family, but doing so is worth it. Not only are you saving for your child’s future, but you are receiving tax benefits at the same time.

And, of course, you can find more information at vanguard.com/529.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing. If you are not a  taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program. Vanguard Marketing Corporation serves as distributor and underwriter for some 529 plans.