Starting a 529 plan is a great way to start saving for your child's college education. The sooner you start, the more time you have to build your savings. There are benefits to these tax-advantaged plans, as well as penalties if you don't use your savings for qualifying college expenses.
Prepaid tuition vs. savings plans
There are two general types of 529 plans: prepaid tuition plans and savings plans. Both options offer certain tax advantages, but there are also features that are specific to each type of plan.
Prepaid plans lock in tuition prices and may be backed by the state government (if issued by the state). They may only cover tuition and fees, although some plans also cover room and board. There may be limits based on the beneficiary's age, and either the plan owner or beneficiary may have to be a state resident.
Savings plans have fewer limitations than prepaid plans. They can be used for beneficiaries of any age, have no residency requirements and can be used for any qualifying expense, including tuition, room and board, books, fees or required computers. However, they have no government backing and no lock on the cost of tuition.
Tax benefits and penalties
Specific tax benefits and penalties depend on the rules of your chosen 529 plan. In general, the money you earn through a 529 savings plan is not subject to federal tax as long as you use it toward qualifying college expenses. It may also be exempt from state tax, depending on your plan. However, if you withdraw money and use it for other purposes, you will have to pay taxes on it along with a 10 percent federal tax penalty.
Fees and expenses
There are many different 529 plans, and each has its own fees and expenses. It is important that you understand all of the associated fees before choosing an investment plan. You may be able to reduce your expenses by selecting a direct-sold college savings plan from a state, instead of buying into a plan through a broker.
While a 529 plan offers tax benefits, there are limits on how much you can contribute. Each plan sets its own total contribution limits, but most savings plans have limits higher than $200,000. Prepaid tuition plans often base their lump sum or installment contribution limits on the beneficiary's age and the amount of college tuition purchased.
Investing in a 529 college savings plan is a smart way to get a jump on future education expenses. Explore your options carefully, checking with your tax preparer, and choose the plan that is the best fit for your financial situation.