When my husband and I found out we were expecting our first child, we had a lot of questions. Everything from “where does the baby sleep?” to “how much sleep will I get?”
Eventually, we made our way to the question, “how do we save for college?” College feels like a long way off (and it is), but with education costs rising rapidly and US student loan debt soaring to over a trillion (with a T) dollars, we figured it might be good to learn a little something about saving for college. I thought it would take a solid google search and just a few minutes for us to have every answer we needed about college savings. And then we could go back to much more exciting things, like amassing a collection of the sweetest little baby booties (I’m obsessed).
After a month I realized that not only had I not answered my initial question of how to save for college, I had so many more questions about the process. It was a big decision and like with most things in personal finance, the options and advice I found felt overly complicated.
But once I finally understood my options and answered all of my own questions, my husband and I were able to make a decision that we feel 100% comfortable with.
There will be nuances depending on your plans for your child’s education and the state that you live in, but this is a basic overview that should get you started quickly on the right path.
What is a 529?
It’s an education savings plan that covers tuition, books, and other expenses at a 2 or 4-year University. (Note: Starting this year, the 529 plan can also be used for private elementary and high school but we’ll focus specifically on college for this article). These plans are run by each state, though you don’t have the participate in the plan offered by the state you live and your child is not restricted to go to college in whatever state you choose for a plan.
Some states also offer pre-paid tuition plans, though the details of how those can be used vary from state to state and these plans, in general, are declining in popularity. We’ll keep it simple here and we won’t talk about any pre-paid tuition programs.
What’s the big deal? Is it really better to put money in a 529 than a regular savings or investment account?
The best benefit of a 529 plan is that it is a tax-advantaged investment account. This means that any of the earnings on the account won’t be taxed if they are used for qualifying education expenses. Let’s say you invest $10,000 in a 529 and over 18 years that investment grows to $15,000. You won’t have to pay taxes when you withdraw that money and spend it on education.
If you were to invest that $10,000 in a regular investment account instead of a 529, you’d be responsible for paying taxes on the gain of $5,000.
Using a 529 plan to save for college is a great way to get some tax savings and maximize every dollar that you’re putting toward your child’s education.
How can it (and can’t it) be used?
Money from the 529 plan can be used to pay for the beneficiary’s qualified education expenses. This includes tuition and fees, as well as room and board if the child is living on campus. If the child is living off campus, the 529 plan can be used to cover room and board costs as long as those costs don’t exceed the amount that is published by the university in their cost of attendance. If the university publishes that room and board should cost $10,000, you can use $10,000 from the 529 to pay for room and board.
How do I know how much to contribute?
This is the big question and it’s completely dependent on your financial situation and your preferences. While you may want to save for your child to go to an Ivy League college, if that’s going to interfere with your own retirement savings, that’s probably not the best idea.
You may also not want to save for 100% of your child’s college expenses if you feel like they should have to contribute in some way as well. There are personal preferences that go into how much you decide to save.
The other factor is trying to determine just how much college is going to cost in the future. College costs are rising rapidly and, while I hope there’s an end to that in sight, it makes it a little difficult to predict what it’s going to cost in the future.
There are a lot of great tools and calculators out there to help you figure out how much you should be putting away. Savingforcollege.com has a really easy to use calculator that can help you get started. When I was trying to figure out how much to save, I started with that calculator to get an estimate. Once I decided to open an account and actually start funding it, I started using the Personal Capital education tool to show me exactly how much I needed to contribute each month.
Is there a maximum amount I can contribute?
There sure is…kind of. In the eyes of the IRS, money that you contribute to the 529 is considered a gift to the beneficiary (your child). The IRS allows each person to “gift” $15,000 per year without having to pay a gift tax. So if you want to contribute to your child’s 529, you can contribute $15,000 per year without the IRS taxing that gift. That $15,000 limit is per person, so if your partner or the child’s grandparents also want to contribute $15,000 each to your child’s 529, they can do that.
My husband and I will both be contributing to our child’s 529. So, technically, we are allowed to invest $15,000 each (or a total of $30,000 together) per year to our child’s 529.
There is also an option to “super-fund” a 529. This means that you can make 5 years of contributions at one time, or $75,000 ($15,000 X 5 years), but then you can’t contribute again for another 5 years. If you have a lot of extra cash sitting around, this gives you the option to kickstart education savings.
When should I start a 529?
If you are financially able to do so, the earlier you start, the better! When you start early, you give your investments more time to grow. You can actually start a 529 before your child is born, though that can be risky because you want to be sure you will actually have a child that can benefit from this account you’ve started.
How do I balance saving for college and saving for retirement?
This has been a big discussion for me and my husband. While we want to help our child with college as much as possible, we also want to make sure we’re financially stable so they’re not having to care for us in our golden years. You can take loans for college but you can’t take loans for retirement.
While everyone will feel differently about this, we’ve decided that we need to secure our own lifejacket first: we are going to make sure our retirement savings comes first and college savings comes second.
This is a personal decision. When you decide what to do, have a really honest look at your finances and how much you can contribute to college savings without putting yourself in financial jeopardy.
Do I have to pick a 529 plan from my home state?
Each state has their own 529 program and some states have better plans than others. You do not have to invest in a 529 plan from your state. And your child is not required to go to college in the state that you have the 529 plan in. So if you invest in a 529 plan from California and your child wants to go to school at Duke University in North Carolina, you can still use that money from the California plan to pay for their tuition at Duke.
However, some states do offer benefits for investing in your home state. For example, if you live in New York and contribute to a New York 529, $5,000 of your contributions can be deducted on your state income tax return each year. If you’re married and filing jointly, you can deduct $10,000 of your contributions.
That’s why, for a lot of people, their home state is the first place they look. For us, our home state of California does not offer a state tax deduction for 529 contributions. This made us feel better about picking a 529 from a different state that was a better match for what we wanted.
What should I consider when I pick one?
Before you sign up for a 529, there are a few things you should consider:
- Does my state offer a state tax deduction for investing in a plan from my state?
- What are the fees associated with the 529 plan? Fees can eat away into the profits that your investments make
- How has this plan performed historically? Has it seen solid returns in the past?
What happens to the money in the 529? Is it safe?
A 529 is an investment account, which means that the money you deposit will be invested in stocks and bonds. Just like with any investment, there is some risk that the value will go down.
Most plans take an “age-based” approach. This means that when your child is young, the investment you make into the plan will go into riskier investments (like stock funds). As your child gets older, your investment will move into more conservative options (like bond funds) so you can breathe a little bit easier about having money there when you need it. Before you invest in the fund, you’ll be able to see a breakdown of how your money will be invested over time as your child gets older.
What happens if my child doesn’t use it?
There is a chance that your child may not go to college – or that they might get a scholarship and won’t need the money in the 529. So what happens to it then?
You can always transfer the money to another beneficiary in your family, such as another child in your family. Or if you decide that you want to go back to school, you can use that money yourself. If you have a niece that you’re really fond of, you can transfer the money to her. You have options.
If you don’t have any other beneficiaries to transfer it to, you can still withdraw the money, but there are 2 catches:
- You’ll have to pay taxes on the money the investment has earned. Remember that’s a key benefit of the 529 – you don’t pay taxes on the earnings.
- You’ll have to pay a penalty fee of 10%. That’s why it’s good to make sure you’re not overfunding the account.