The growing cost of tuition can place an overwhelming hardship on families wishing to send their children to college.

Planning ahead can substantially ease this burden. A 529 plan is a valuable tool for many families.

A Quick Lesson: A 529 plan is a savings plan, similar to a retirement account. It gets its name from the tax code section that created it.

States (or sometimes eligible educational institutions) establish and maintain these plans.

These plans allow the account holder to either prepay a child’s school expenses or contribute to an account that will pay for those expenses when the time comes.

How a 529 Plan Works

Simply put, a 529 plan is a tool to shift money from the government to your child’s education.

Typically, the government taxes money that your child’s college fund earns (i.e., the interest or investment growth). In a 529 plan, those earnings aren’t taxable. Though this may seem like a minor benefit, but over the course of a decade or two, this can generate thousands of additional dollars.

As an added bonus, many states offer tax deductions or credits for contributions made to a 529 plan.

Additionally, a recent tax law change could help you benefit even more from 529 plans. Please check out this guest post to learn more.

Types of 529 Plans

There are two main types of 529 plans.

Prepaid Tuition Plan

A prepaid tuition plan lets you purchase credits at participating colleges and universities (usually in-state and public ones). The beneficiary can use the credits towards future tuition and mandatory fees, but you pay for them at current prices. If you’ve watched the price of college increase over the past 30 years, you can guess how advantageous this plan could be. By locking in tuition costs at current market levels, you could potentially save thousands of dollars.

There are some details to consider, though. For example, not all states offer prepaid tuition plans. Of those that offer them, most have residency rules. Additionally, the federal government doesn’t guarantee prepaid tuition plans – nor do some of the state governments. This means that there is a risk that you lose some or all of the money you paid into the plan. Also, if the beneficiary doesn’t wind up attending one of the participating schools, the payout from the plan may be much less than you had hoped for.

Education Savings Plan

Education savings plans are the more commonly used version of the 529 plans. An education savings plan is an investment account used to save for the beneficiary’s tuition, mandatory fees, and room and board. All states offer these kinds of plans, and most states don’t have residency rules for them. However, neither the state nor the federal government will guarantee most investments in these plans.

These plans offer the most flexibility to you and the beneficiary. For example, many brokers offer college savings plans according to your particular needs. If Junior (who is many years away from college) is the beneficiary of a 529 plan, you can direct that the plans’ funds be invested aggressively. Once Junior enters high school age, you can shift the fund towards a more conservative investment strategy. When Junior is ready for college, he can select from most U.S. (and some non-U.S.) schools.

Who Gets the Money?

When you create a 529 plan, you will name a beneficiary. In most instances, this will be your child. However, there is no requirement that it be a child or even a family member. Whoever you name as the beneficiary will receive distributions for qualified educational expenses.

Changing beneficiaries is easy. The IRS doesn’t assess a penalty if you change the beneficiary to a qualifying member of the beneficiary’s family. Additionally, if you want to rollover (or transfer) assets from a 529 plan, you can do this tax free. It is generally tax free if you roll it over into another 529 account or an ABLE account (a plan for those with disabilities) for the beneficiary or the beneficiary’s qualifying family member.

Please be aware that there is a possibility that the assets in a 529 plan can affect a student’s financial aid eligibility.

Taking Money Out of the 529

All 529 plans allow you to make withdrawals for qualified tuition and mandatory fee payments. Education savings plans allow you to also make withdrawals for room and board, as well as other qualified education expenses (such as a new computer for school).

However, should you fall on hard times and need to withdraw the funds for an alternate purpose, the cost can be high. You will have to pay taxes on any earnings you withdraw. The IRS also tacks on an additional 10% penalty. Therefore, you should avoid non-educational withdrawals from the 529 plan unless it is absolutely necessary.

What questions should I be asking?

If you are contemplating a 529 plan, the SEC has put together a great list of questions to consider. Among the most important:

• Is the plan available directly from the state or plan sponsor?
• What fees are charged by the plan, and what goes to my broker?
• What are the plan’s withdrawal restrictions?
• Which colleges and universities participate in the plan?
• What if my beneficiary does not need the 529 funds for college?
• What types of investment options does the plan offer?
• Does my state’s plan offer tax advantages or other benefits for investment in the plan it sponsors?
• How has the plan performed in the past?

Is a 529 right for me?

If you are sitting at home with a toddler, or even just staring at your first ultrasound, college can seem like a very distant concern. Given all the uncertainties of life, you may be fearful to allocate such a large quantity of money towards something that may not be necessary. Many kids don’t end up attending college, and many others get scholarships covering all of their expenses.

However, for the vast majority of Americans, college is a part of life, and it is costly.  Starting a 529 plan now could generate thousands of extra dollars for school and prevent your child from becoming a student loan horror story. If you have multiple kids, the probability that you can utilize your 529 plan is particularly high.

Choosing to create a 529 plan early not only offers tax advantages, but it also helps develop good savings habits. It encourages people not to touch those funds for any other reason. These advantages and incentives can help you on your way to maximizing the college opportunities for your child or children.

Further Reading:
The Wall Street Journal on how to pick a 529 (subscription required)
The Wikipedia entry on 529 Plans
IRS Q and A on 529 Plans

Have you started or been a beneficiary of a 529 plan?  How did it affect your college experience?

The post 529 Plan Basics: An Easy to Understand Guide to College Planning appeared first on The Student Loan Sherpa.