If you’re planning to send your kids to college, you might want to begin saving as soon as they’re born.
The cost of community college and state universities starts around $10,000 these days, and for an Ivy League school, the cost is closer to $60,000 per year, and rising. In other words, you need to be planning now.
You could start a savings account in your child’s name, depositing money on a regular basis, but the interest will be taxed every year. You could decide to use a portion of your own 401(k) retirement account for your college-age child but you’d have to pay taxes on that, too. Or better yet – you could start a 529 college savings plan which gives you a tax advantage while saving for the college goal.
The 529 plan, enacted by Congress in 1997, has 10 million subscribers who are taking advantage of a program which saves after-tax dollars in an account that is invested to grow. Funds from a 529 account can be used at any accredited post-secondary institution in the United States and at some institutions outside the U.S.
Withdrawals from the plan are not taxed because they were made with after-tax dollars. Earnings on the plan are not subject to federal taxes, and most states do not tax the earnings either.
If the money is not completely spent by the time your child finishes college or graduate school, it can be transferred to a younger child. As the owner of the plan, you are entitled to change the beneficiary if you wish, or if the plan allows, you can take back the money. If you do take back the money, you will owe income taxes on the earnings and a 10 percent federal tax penalty (unless the beneficiary dies or becomes disabled).
“Savings plans work much like a 401(k) or IRA by investing your contributions in mutual funds or similar investments,” according to the savingforcollege.com website. “The plan will offer you several investment options from which to choose. Your account will go up or down in value based on the performance of the particular option you select.”
This premier site on 529s has tutorials for setting up a 529 account and details on state-by-state plans. It includes a list of eligible schools and other advice on the best way to pick a good plan.
Savingforcollege.com recommends looking first to your own state which may offer a 529 plan and some tax breaks such as an upfront deduction for your contributions or income exemption on withdrawals. If you don’t get any benefits from your state, it’s time to shop around for better deals in other states.
It’s important to take time to compare, and also to talk with a reputable professional who could help you make sense of the sea of options. Some colleges offer their own versions of a 529 plan, so if you have a particular college in mind, check to see if they participate. It’s never too early or too late to consider a 529 plan.
Here’s what you need to know:
- There is no annual limit on how much you can contribute to your 529.
- You or other family members can contribute up to five years’ worth of gifts in one year and still be covered by the annual gift tax exclusion. The gift tax exclusion for 2016 is $14,000 (unchanged from 2015). Thus, you can contribute up to $70,000 to a plan gift-tax-free in one year. If the gift is split with your spouse, you can contribute up to $140,000. However, if you die within the five-year period, a pro-rata share of the $70,000 returns to your estate. Grandparents can set up accounts for grandchildren, transferring large sums from their estates while providing for their grandchildrens’ education.
- You can shop around for the best plan, looking into ones offered by every state and the District of Columbia. Some states have better investment options, others have higher fees. The plans can differ significantly among states. For example, some states offer very similar investment options but have much different expenses. Others are very competitively priced but have very different investment menus. Your home state may require you to spend this tax benefit at a college or university within the state to avoid state taxes.
- Room and board, buying a computer for use in a classroom or a tablet to read e-books is covered.
There are two kinds of 529 plans:
1. Prepaid tuition plans allow a person to buy tuition credits or certificates, which count as units of attendance. The number of units doesn’t change even though tuition will likely increase before the beneficiary gets to use the tuition credits. They are an asset of the plan owner, and their worth is the refund value of the credits or certificates.
2. College savings plans allow a benefactor to deposit money into an account which will be used for the beneficiary’s college expenses. This type of plan is essentially a savings account, and its value as an asset is the current balance of the account.
Adults Can Also Take Advantage of Section 529 Plans for Tax-Smart Learning
Contributing to a Section 529 plan on behalf of children or grandchildren can be a wise idea. But have you ever thought about one of these tax-favored accounts for yourself – to pay for post-secondary courses you might want to take in the future?
Adults can open up Section 529 plans (also called Qualified Tuition Programs) and make themselves the beneficiaries. The plans allow you to put money in a state plan for tuition, fees, books, supplies and the equipment required to attend an eligible educational institution.
What’s an eligible school? “It includes virtually all accredited public, nonprofit and proprietary (privately owned profit-making) post-secondary institutions,” according to the IRS.
This means you can generally use withdrawals to study for a second career, go to graduate school or do coursework in retirement.
Section 529 advantages include:
- Your account grows tax-free and withdrawals are not federally taxed when used for eligible education expenses.
- Many states allow income-tax deductions (up to different annual maximums) for contributions to the state’s plan – and some don’t tax withdrawals.
- There are no income limitations and you can put a substantial amount into a plan at one time.
What if you don’t use the money? You can change the beneficiary to a family member or leave the account alone and let it become part of your estate. Another option is to withdraw the money. However, the earnings will be subject to federal (and any state) taxes, as well as a 10 percent penalty. (The penalty doesn’t apply to the principal.)
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