How Does A 529 Plan Work?

For many families, paying for college tuition is a tremendous struggle. This is especially true they did not prepare ahead of time. If you have a future college student in your household, the best time to start saving money for this monumental cost is today. A viable option for many families is the versatile 529 plan. This popular plan allows parents to save money now in order to pay for college costs later. 

Account Setup

529 plans are usually sponsored by state governments. During the account setup process, parents have the option to choose between two types of 529 plans, college savings plans and prepaid tuition plans. Prepaid tuition plans allow parents to buy actual future credits at a participating university or college. College savings plans permit families to contribute money to an investment account that will cover future college expenses. Prepaid tuition plans have residency requirements. Fortunately, college savings plans do not. 

If you choose to invest your money in a college savings plan, you can do some comparison shopping among different states. You may even reside in one state, purchase a college savings plan in a second state, and send your child to a college or university in a third state. Do you have more than one child? If you will be paying for multiple college students in the future, you can open more than one 529 plan. Only one student can receive benefits from an individual 529 plan. Added bonus? 529 plans don’t have familial requirements. You can initiate a 529 plan for a neighbor, a friend’s child, or a grandchild.

Contributions

Each year, investors make contributions to their 529 plans. Typically, the amount contributed can be as small or as large as you like. Most 529 plans have lifetime contribution limits in excess of $200,000. Unlike other types of investments, you can only donate cash to this kind of savings option. You can’t roll stock or other types of securities into your child’s account. 

Income Accumulation

Income will accumulate in your college savings vehicle until you are ready to use it for college expenses. This income will grow tax-free. Unlike general investments in the stock market, bond market, or capital assets, you will not have to pay taxes on your earnings. This benefit can only be secured if you eventually use your investment money to pay for qualified post-secondary educational expenses. For instance, you can’t take money out of your account to buy a new car, pay for a vacation, or pay down your debt. 

If you spend your account earnings on non-educational items, you will be forced to pay taxes on your earnings in addition to a 10% penalty. In the event a child decides not to attend college, a college savings account can be transferred to another future student. In some cases, it can also be rolled into another type of investment vehicle without penalty.

Expense Disbursements

When your child enters college, you can use the money in a 529 plan to pay for all qualified educational expenses. The characterization of qualified educational expenses differ for prepaid tuition plans and college savings plans. Both plans permit the use of funds to cover mandatory fees and tuition. College savings plans also allow the account to pay for books, computers, and room and board.

If you’re apprehensive about your child’s future college expenses, you should consider making contributions to a 529 plan. This will allow you to accumulate money tax free until your son or daughter leaves the nest to attend college.