How to Start a 529 College Savings Plan

A 529 plan, named for the section of the Internal Revenue Code that created it, is a type of investment account that allows you to save for college.

Why are 529 plans so great? It all has to do with taxes. With 529s, you have to pay normal income tax on the money you put into your plan. But you don’t pay taxes on the investments’ earnings once they’re parked in the account, or when you take them out to pay for college. This is always the case, as long as you use the proceeds for tuition, room, board or other college-related expenses.

If you start early and save over time, this is a tax break worth thousands of dollars. It’s also one of the few lucrative tax incentives for savers that does not disappear when your income gets too high (the way it does with a Roth IRA retirement account, for instance).

Thanks to the odd way in which these accounts came into existence, you don’t just set up a 529 plan the way you would, say, an IRA. Almost every state has a different 529 plan, and many states have several. Each state picks a single administrator, like Vanguard, to run its plan and handle accounts for investors. These investment managers become, in effect, the brokerage firm for your college savings money. If you want to invest with the plan in your state, you have to work through the state’s administrator. You don’t have to invest in your state’s plan, however – you can invest in any state’s plan. But in general, you can a better income-tax deduction by contributing to your own state’s plan.

You also have the choice of getting a plan directly sold to you or through an adviser. The direct-purchase option can be cheaper, but some prefer the advice and services that come with having an adviser administer the plan.

There are two main kinds of 529 plans:

  • Prepaid Plans: With prepaid plans, you pay for a year (or a portion of a year) of tuition ahead of time, effectively locking in the price. You may be able to pay today’s tuition rate, or some states require a bit more to be paid for this privilege. But then you’ve effectively locked in tuition for your kid’s school at any point in the future – no matter how much tuition has risen by the time your kid enrolls.
  • Investment Plans: The prepaid plan may sound enticing, but we think an investment plan is the better choice – especially for parents with younger children. With investment plans, you choose how you want to invest your funds and then you can use that money (and the earnings it generated) for a variety of educational costs at a variety of institutions.

You can raid your 529 funds for non-educational needs if you get into a tight spot. But you’ll be penalized — first, you must pay ordinary income tax rates on the gains, plus a 10% penalty to the government. There are some exceptions; if your child wins a scholarship, becomes disabled or dies, you can take the money out without penalty.

Concerned that you’ll miss out on financial aid if you start saving now? You shouldn’t. The federal formula for calculating aid eligibility only expects parents to use 5.64% of 529 balances each year to pay college expenses. So there’s not a huge financial-aid penalty for saving money. Plus, financial aid packages have a lot to do with your income, and nobody can say for sure what their income will be 10 or 20 years from now.

There can be a massive penalty, however, for assuming financial aid will take care of things 15 or 20 years from now. By then, you may make too much money to qualify. And, realistically, most aid is in loans anyhow.

Worried that you’ll sock too much away? Well, it’s pretty much impossible to over-save in a 529 account. You can use extra money to pay for graduate school. You’re also allowed to change the beneficiary of a 529, usually at least once each year. So you could use leftover money from your first born for a second child, or let it ride another 30 years for your grandchildren.

You can even use a 529 plan for yourself. How about taking an art class…in Rome…when you retire?