Saving for college: 529 versus alternatives

In short

A friend of mine once told me she felt behind on college savings before her daughter could even walk. If you feel that way too, take a breath, because you are in good company. A 529 plan is a savings account built for education, and the growth inside it is not taxed when the money goes to school costs. Your state may offer its own plan, so look at that first, then compare a few others on fees. You can open one with a small deposit and add a little each month. If you would rather keep more choices open, a Roth IRA or a plain savings account can also do part of the job. Small steps count. Take the first one when you are ready.

The whole of it

What it is

I once watched a neighbor spend an entire summer sorting out how to pay for his son's first year at a state school. He had money saved, but it sat in three places, and each place had different rules. That is the trouble a 529 plan tries to fix.

A 529 plan is a savings account, named for a section of the tax code, that you use for education costs. You put in after tax dollars. The money is invested, and the growth is not taxed when you take it out for qualified expenses. Qualified expenses include tuition, fees, books, and certain room and board costs. Many states also let you deduct part of your deposits on your state return, though that depends on where you live.

There are two kinds. A savings plan invests your money in funds you choose. A prepaid plan lets you lock in tuition at certain schools at today's price. Plenty of families look at the savings kind, so that is where I will spend our time.

You stay in charge of the account. The owner picks the investments and decides when to take money out. The beneficiary is the child who will use it. If that child goes another way, you can change the beneficiary to a sibling, a cousin, or even yourself.

How it works

A friend of mine opened her account online in about twenty minutes. She named her son as beneficiary, chose a mix of funds, and set up a small monthly transfer. That is nearly the whole process.

Once the money is in, it grows or shrinks with the investments you picked. Many plans offer an age based option. That means the mix starts out heavy in stocks when the child is young, then shifts toward safer holdings as college nears. You do not have to move anything yourself.

When the bill comes, you pull out what you need and send it to the school or back to yourself. Keep the receipts. If you take out more than the qualified costs, the growth on the extra part is taxed as income, and a penalty can apply. So match your withdrawals to your bills in the same calendar year.

Now for the alternatives. A Roth IRA is a retirement account, but you can take back your own deposits at any time without tax. That gives you a fallback if college costs less than you feared. A regular brokerage account has no special tax break, but it has no rules about how you spend the money either. A plain savings account is safe and simple, though it grows slowly. A Coverdell education savings account works much like a 529, but it has a low yearly deposit cap and income limits.

Each choice trades something. The 529 gives the strongest tax break for school. The others give you room to change your mind. Many families use a mix.

The numbers, and where to find yours

You have probably wondered how much you are allowed to put in. Deposits to a 529 count as gifts for tax purposes. The yearly gift tax exclusion is the current figure, which the official source publishes each year, and you can find the current figure on the IRS website. There is also a special rule that lets you front load five years of gifts at once, which is described in the IRS instructions for Form 709.

Each plan sets its own lifetime cap on account balances, so check your plan's disclosure booklet. Your state's deduction, if there is one, appears on your state tax agency's website or in your state plan's materials.

The Roth IRA has a yearly deposit limit of the current figure, which the official source publishes each year and an income range where the ability to contribute phases out, listed at the current figure, which the official source publishes each year. The Coverdell has its own yearly cap, the current figure, which the official source publishes each year. To see any of these, visit IRS.gov and search the name of the account.

Fees matter too. Every plan lists an expense ratio, which is the yearly cost as a share of your balance. Find it in the plan's program description. A small difference in fees adds up over eighteen years. Look at it closely.

A worked example

Let me tell you about Maria. She is thirty four, earns 52,000 dollars a year, and has a daughter named Sofia who is two. Maria wants to start saving but does not have much to spare.

She decides to set aside 100 dollars a month. Over one year, that is 100 times 12, which equals 1,200 dollars in deposits. Over sixteen years, until Sofia turns eighteen, that is 1,200 times 16, or 19,200 dollars in deposits.

Now, growth is never certain, so Maria does not count on a set return. To be careful, she runs a plain check with zero growth. Deposits alone come to 19,200 dollars. If the account earns something, she ends up with more. If it earns nothing, she still has the 19,200 dollars she put in.

Her state gives a deduction on 529 deposits. Suppose that deduction is 1,200 dollars a year and her state tax rate is 5 percent. Her yearly saving on taxes is 1,200 times 0.05, which equals 60 dollars. She checks her own state's rules to confirm, because those figures are only for this example.

Maria also keeps a small cushion in a regular savings account. That way, if the car breaks down, she does not have to touch Sofia's fund.

Where it goes wrong

I have seen good people trip on a few simple things. The first is pulling money out for a cost that is not qualified. You end up paying tax and a penalty on the growth. Read the list of qualified expenses before you withdraw.

A friend of mine picked a plan without ever looking at fees. High costs quietly eat into the growth, and she did not see it for years. Compare a few plans before you commit.

Some folks put in so much that they starve their own retirement. The plain fact is that college can be paid for with loans, while retirement cannot. That is worth weighing before you decide how much to send to a 529.

You have probably heard that a 529 can affect financial aid. The account is counted in the aid formula, though the rules depend on who owns it. The Federal Student Aid website, studentaid.gov, explains how the formula treats these accounts. It is worth reading before you pick an owner.

Last, some people wait for the perfect moment. There is none.

Questions to answer before you leave this page

Have you looked at what your own state offers, and does it give a tax break on deposits? Do you know how much you can set aside each month without hurting your retirement or your emergency cushion? What are the yearly fees on the plan you are considering, and have you compared them with one or two others? Would you feel better with the flexibility of a Roth IRA or a savings account alongside a 529? Who will own the account, and who will take over if something happens to you? And what is one small step you could take this week?