There's no question that college is expensive. And there's no indication that the cost is going to go down anytime in the future. If you want to be able to pay for college (whether for your own or your kid’s education), you'll need to start saving money right off the bat. One of the best ways to do that is to get a college savings plan — specifically, a 529 savings plan.
A 529 plan is a college savings plan which was created by the addition of Section 529 of the Internal Revenue Code (IRC) way back in 1996, hence the name. So, what makes this plan so different from just a regular savings account? One word: taxes. With a 529 plan, you aren't required to pay taxes on any earnings from the money you've saved in the account. You also aren't required to pay taxes when you withdraw money from the account to pay for college. Even better, this tax incentive does not disappear even if your income gets too high.
Does that mean you can use your 529 plan for any college? It depends. Depending on the type of plan you get, you can use the money to pay for college costs at any eligible college. There are actually over 6,000 colleges and universities in the US that are qualified under 529 rules as well as more than 400 colleges and universities outside the US.
Here’s more good news for you. Each of the 50 states as well as the District of Columbia offers at least one 529 plan. Some even have several. Plus, you don't necessarily have to get a 529 plan from your own state or even use the plan to go to college in the state you got it from. For example, you can live in New York, get a 529 plan in California, and use it to go to college in Texas. What's important to note, however, that these plans may differ from state to state, so you need to do a bit of shopping around to find the one that suits you best.
Before you go looking for a 529 savings plan, you need to become better acquainted with the two main kinds available: prepaid tuition or a college and education savings plan.
Prepaid Tuition Plans
As the name suggests, this type of 529 plan allows you to pay for units or credits at eligible colleges and universities at the current price for future use. Basically, you've locked in the cost of the tuition at your kid's school, and you don't have to worry about the continued rise of tuition over the years. However, this kind of 529 plan does not include paying for future room and board. Most of these plans are state government-sponsored and may have residency requirements for the saver, beneficiary, or both. In addition, not all state governments will guarantee the money. Moreover, these plans typically only work for in-state, public universities which limits your kid’s future options.
College Savings Plan
This is an investment plan where you can save money into an investment account to pay for future college costs which include tuition, mandatory fees, books, equipment, computers, and room and board. With this type of 529 plan, you will be able to choose among several investment options such as mutual funds and exchange-traded fund portfolio (ETF). Of course, the value of your 529 plan account can go up and down because of the performance of your investments. But in general, this is considered the best option, especially if you have young kids. In addition to covering more expenses, you can also raid your 529 plan in case of an emergency. There is a penalty, however. You will need to pay ordinary income tax rates on the earnings of a non-qualified withdrawal as well as a 10 percent penalty to the government. The good news is that penalty is waived if the beneficiary of the plan receives a tax-free scholarship, attends a US Military Academy, dies, or becomes disabled. Just take note that the earnings will still be subject to federal and possibly state income tax.
The first thing you need to do before you open a 529 plan is to check what's being offered, especially in your state. Most states want you to keep your money at home which is why they often offer incentives to residents who choose their own state's plans. These incentives are state income tax deductions or income tax credit. You might want to stick with your own state if you get that extra tax break. If your state doesn't offer that kind of incentive, you'll need to check out all the plans offered by every state.
After choosing the state, you'll need to choose between a prepaid plan or a college savings plan. Prepaid plans are best if your kid is in his or her teens and already has his or her eye on one of the state universities. This plan allows you to pay for tuition at today's discounted rates. However, if you're starting out early, you'll be better off with an investment plan. Make sure to choose one that has fees lower than 0.75 percent. In addition, check the minimum contributions and investment options.
After picking your plan, make sure that you're familiar with the rules and terms of your chosen 529 plan. To enroll in a specific plan, you'll have to get in touch with the state administrator that runs the plan and handles the investment accounts. Some states allow you to buy an education savings plan directly, enabling you to save on broker-charged fees.
You'll need to name the account owner (we're guessing it's you) and the beneficiary which is the person who will be using the money for college (ideally, your kid). You'll also need to decide on how your money will be invested. With an adviser, you may be paying some extra fees, but you will have an expert in charge of administering the plan.
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