Plenty of savings vehicles help parents finance their child’s college education – and with student debt on the rise, those savings can minimize the financial burden when college graduates move into the working world. One of the most popular savings plans is a 529, which comes in two flavors that let you either prepay tuition or save for it in a tax-advantaged account.
One word of caution before contributing to a 529: Consider your own retirement needs. Many financial advisers recommend that parents first fund their own 401(k) retirement plans up to the point of their company’s match and contribute the maximum amount allowed to their individual retirement account (IRA). Then it’s time to save for your child’s college education.
Here’s how the two versions of the 529 work:
529 college prepaid plan
The 529 college prepaid plan allows savers to purchase credit points for a university in their state at the current rate. This means that if tuition costs increase due to inflation or other factors, parents are protected from paying those higher rates. However, it’s important to note that with this prepaid plan, parents should be confident that their child will attend a particular school in their home state and know that the credits only cover tuition costs and mandatory fees.
529 college savings plan
The 529 college savings plan is similar to a 401(k) in that it’s a tax-advantaged account that allows savers to grow their earnings on contributions tax-free. The money can then be used toward paying any educational expenses including tuition costs, books, room and board, computers, etc. In addition there are no age or time limits with the savings plan as there are with the prepaid plan.
Depending on what state’s plan you decide to use, there are different investment options based on factors such as asset allocation and risk level. You can choose a plan belonging to a state other than your own, but be sure to check whether your state plan offers any tax deductions that you could take advantage of.
For a list of the best 529 plan options by state, be sure to check out NerdWallet Investing’s comparison, which includes information such as the minimum amount needed to start your account and the number of investment options available.
Each person is allowed to contribute up to $14,000 per year to a 529 account, meaning a married couple can contribute a total of $28,000. In addition, each person has the ability to contribute five years worth of contributions at one time but will then need to wait until the sixth year to start contributing again.
Many parents start saving for their child’s college before they’ve fully funded their retirement. That’s a mistake, financial advisers say, because students have multiple options when it comes to paying for their college educations – scholarships, grants, loans, etc. But there’s essentially only one way to finance your retirement: through your own savings. This is why you should prioritize saving for your retirement over saving for your child’s college tuition, as much as your parental instincts might insist otherwise.
Also, you can use one type of retirement account – the Roth IRA – to pay college costs without penalty. Financial advisers are split on whether this is a better solution than a 529 is. Proponents point to the Roth’s greater flexibility in investments and lower costs. Others point out the pitfalls of using a Roth as your primary college savings plan.
The federal government divides the money in your Roth into two piles. Contributions you make to a Roth IRA are always available tax and penalty-free, whatever you use the money for. But the money earned in the Roth comes with a 10 percent early withdrawal penalty if you take it out before you turn 59-1/2. You can get around that penalty if the money is used to pay for college (which is why some advisers like the Roth as a college savings plan). But you’ll still have to pay ordinary income tax on those earnings if you don’t meet the 59-1/2 age threshold and the IRA is less than five years old.
Worse, advisers warn, the money you take out from the Roth will count as extra income if you apply for financial aid the following year. And the money won’t be available for retirement, of course. However, if you find yourself in good shape for retirement but short on college cash by the time your son or daughter is ready to head off to school, you could consider using your Roth IRA to fill the gap.
What if your child doesn’t go to college?
You may withdraw from your account with both the 529 savings and prepaid plan but the withdrawals will be subject to a 10 percent penalty. In addition, any earnings withdrawn may also be subject to federal and income tax.
However you can also roll over your account from one member to another and change the beneficiary name on the account so that the money can be used toward another child’s tuition.
– Neda Jafarzadeh is a financial analyst for NerdWallet, a financial literacy organization committed to helping consumers better manage their finances.