Saving For College With A 529 Account

In most circumstances, a 529 account is the best way to save money for college. I’ll explain how they work.

As with a Roth IRA, you contribute to a 529 account with after-tax funds and the money grows tax-free. If you eventually use the funds for qualified educational expenses, you will pay no tax on the investment income that you generated over time.

For somewhat odd historical reasons, 529 accounts are administered by each state, even though they’re governed by IRS rules. However, a participant can chose any state’s plan in which to invest.

The advantage of choosing your home state’s plan is that your state may offer state income tax incentives for contributing to it. The disadvantage is that you state’s plan may have inferior investment choices and higher fees. So, you should choose carefully as not all 529 plans are created equally.

There are other advantages to using a 529 to save for college:

  1. K to 12 private school educational expenses also qualify.
  2. You can change the beneficiary to another family member. If you have multiple kids or grandchildren and one or more of them choose not to attend college, you can make another child the beneficiary.
  3. You can roll over your account to a new plan. For example, it may make sense to contribute to your state’s plan to receive a state tax deduction and then roll over the funds to a better plan later. However, some states are hip to this move and may recapture the state tax benefits they gave you if you do a rollover, so proceed carefully.
  4. There are high contribution limits. Unlike a Roth IRA, there are no effective limits to what you can contribute to these plans (other than the full cost of attendance of the college education). For wealthy contributors, this can save a significant amount of future taxes.
  5. While the student is the beneficiary of the fund, you remain the owner and have full control over the account and the disbursements from it.

If you’re wondering, saving money in a 529 account does not reduce the family’s eligibility for need-based financial aid, assuming the money would have been saved elsewhere and used to pay for college. However, if you think you’ll be eligible for need-based financial aid, a Roth IRA can be better than a 529.

Why is that? The FAFSA financial aid form does not include retirement assets such as IRAs, however it does include 529 account balances. Thus, if you’re eligible for a Roth IRA, max that out before saving in a 529 as the Roth money will be excluded. You can withdraw your contributions from a Roth IRA without penalty or tax when you’re ready to pay for college.

What happens if you don’t use the funds for qualified educational expenses? When you withdraw the money for non-qualified purposes, you will pay income tax on the investment gains, plus a 10% penalty (on the gain). This is costly because you will have paid ordinary income tax on what would have otherwise been a long-term capital gain that would have likely been taxed at roughly half that rate.

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