From the Archive: Saving for College
A 529 plan is the most tax-efficient way to do so
Are you saving for your child or grandchild's education? In most circumstances, a 529 college savings account is the best way to do so.
As with a Roth IRA, you contribute after-tax funds to a 529 account and the money grows tax-free. If you use the funds for qualified educational expenses, you'll pay no tax on the investment income that you generated over time.
529 accounts are administered by each state, but a participant can chose any state's plan in which to invest. The state-based plan structure seems unnecessary but nothing is rational about the tax code.
The advantage of choosing your home state is that your in-state plan may offer some limited 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.
Besides the tax savings, there are other benefits to using a 529 to save for college:
K to 12 private school educational expenses can qualify.
Graduate school and accredited trade schools also qualify.
You control the funds and how they’re ultimately used. If you have multiple kids or grandchildren and one or more of them choose not to attend college or gets a scholarship, you can change the beneficiary to another family member.
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.
There are high contribution limits — essentially, up to the full cost of attendance of the college education. For wealthy contributors, this can save a significant amount of future taxes, especially if you fund it early in junior’s life.
Lastly, you can now contribute up to $35,000 of leftover funds into the beneficiary's Roth IRA. You have to jump through some hoops to qualify, but this can be a valuable way to transfer some assets to your child.
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. 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 from the financial aid award determination.
What happens if you don't use the funds for qualified educational expenses? If 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 would pay ordinary income tax on what may have otherwise been a long-term capital gain that may have been taxed at roughly half that rate. However, there are lots of qualified ways to use the money.
For educational savings, the advantages of a 529 are significant and worthwhile, especially if you start when the kid is young.