If you want to help pay for higher education for a child or grandchild, consider using a 529 college savings plan. These plans allow you to put money aside for tuition and other college-related expenses, while getting some nice tax advantages as well. Since I have a son who will be college bound in a couple of years, I've looked at all sorts of ways to pay for it and can say the 529 plan is by far the best for me.
While 529 plans are sponsored by each state, your student can use the money to attend school in any state as well as many universities abroad. And depending on where you live, you may get a state tax deduction when you deposit the funds. Any earnings or gains are exempt from federal and state levies as long as the money is used to fund college tuition or room and board.
There are two types of 529 plans: prepaid tuition plans and college savings plans. I almost always prefer the college savings plans, as the prepaid tuition plans typically have limits on the schools the child may attend. Here are some steps you can take to pick the right plan and investments.
First, check to see if the state you live in offers a tax deduction for any money you contribute. Savingforcollege.com has a list of states allowing deductions and the amount that can be contributed. It usually makes sense to put money in your own state's fund up to the amount of the deduction. This saves you cash up front and, for example, if you contribute $1,000 and are paying taxes at the 7 percent state tax rate, you would save $70 when you file your tax return.
If your state doesn't offer a deduction or has no state income tax, then pick whatever state plan you like. Because fees matter in all investing, I look for the lowest costs and best investment choices. Every year, I evaluate each state and pick my top five 529 college plans. It's not just an exercise for me because I can move my son's college money once a year. I chose Utah as the best but here are my five top finalists. All had fees of 0.25 percent annually or less.
All five of these plans are "direct" 529 plans. Most states also offer an adviser-sold plan that pays the adviser for putting you in that plan. I generally avoid those adviser-sold plans because you're one paying the adviser via higher fees.
Once you have chosen a plan, there is no need to worry if your knowledge of investing is limited, because every direct plan has what is known as an "age-based plan." The investments automatically get more conservative to protect the account balance from market swings the closer the child gets to using the money for college.
Each state has its own maximum amount you can contribute. Right now, every state allows contributions in excess of $200,000 per child; here is a list. If you contribute more than $14,000 per beneficiary per year, there can be some gift tax consequences. There is nothing simple about taxes, but this IRS page shows 529 rules. You need a separate account for each beneficiary and once a year you can change the beneficiary. Thus, if one child or grandchild doesn't need all the money, you can name a different beneficiary.
If the beneficiary is applying for financial aid, only 5.64 percent of the 529 balance will be counted if owned by the parent and none if owned by the grandparent. Thus, it can be better if the grandparent owns the 529 plan, though distributions from a grandparent's 529 may reduce a grandchild's aid in subsequent years.
Downsides of 529 plans are that generally even the lowest-cost states listed above have higher fees than the lowest-cost index funds one could buy outside of the 529 plan. If the child decides not to go to college, you have to pay a penalty equal to 10 percent of any gain as well as regular income taxes, which would have to be paid anyway. You can avoid this penalty and taxes by changing the beneficiary and even naming yourself if you want to take in some post-secondary education.
Photo: Tax Credits.Net/Flickr
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