Planning for college – for yourself or for a child – involves the inevitable explorations of how to pay for it. Your best bet is is to start a savings plan ahead of time to handle future expenses. Obviously, the more you can save ahead of time, the less debt you’ll take on in student loans. Plus, you can get certain tax benefits with college savings plans. Here’s how.
The 529 Plan
Just about every state has what is called a 529 plan (the IRS calls them Qualified Tuition Programs), which is an education savings plan operated either by an educational institution or by the state itself. The name comes from Section 529 of the tax code, which authorizes this type of plan. But even though just about every state has an education savings plan, there can be differences, so it pays to compare.
There are two types of 529 plans:
- Savings programs, where the entire account can be used at any accredited college, university or other school*. It’s a lot like an IRA account, where the contributions are socked away in some sort of investment vehicle, like mutual funds.
- Prepaid plans, where the in-state tuition is paid in up-front. Initially, this type of plan was set up with a particular college or university in mind. But many states now allow them to be transferred to another institution (although it may be at a lower rate, depending on the state). And colleges themselves can also offer a 529 prepaid tuition program.
* Up to $10,000 from a 529 plan can be used to pay for public, private or religious elementary or secondary school tuition. The amount is per beneficiary.
Federal & State Tax Implications
You can’t deduct your contributions to a 529 plan on your federal tax return, but the earnings in the account are tax-deferred, and distributions used to pay for the beneficiary’s school expenses are tax-free.
State tax benefits vary. Some states allow accumulated earnings to grow tax-free until you take the money out, some allow the distribution to be taken tax-free, and still others designate both earnings and distributions as non-taxable. The terms of your plan will explain how your state treats the funds.
A 529 plan can be used to pay qualifying expenses for a student who is enrolled at least half-time. Qualifying expenses include tuition and fees; books, supplies and equipment; and room and board. Computers and related expenses are also included.
The donor of the account – the person who is making the contributions to the plan – is the administrator for the plan. The beneficiary – the student, usually – doesn’t have any rights to the funds. The donor decides when distributions are made and for how much. A 529 plan may impact financial aid. If the parent is the plan administrator, the calculation is relatively simple; in cases where the student is actually the administrator, the process is more complicated.
Since a 529 savings plan is pretty much on auto-pilot once it’s set up, the donor won’t see a reporting statement for taxes (such as Form 1099) until withdrawals begin.