Everybody knows that their children’s college tuition is going to have to be paid somehow by someone someday.
Starting to save for college seems like a daunting task to many parents of young children. First, the fact that college is so far into the future makes parents feel like there is plenty of time left to start (hint: there isn’t). Second – and by far the most impactful – is the uncertainty of how much college is actually going to cost once your child starts college.
Higher education costs at both 2- and 4-year colleges and universities have been rising steadily over the last decade. These 10-year higher education inflation numbers vary by state. For example, Louisiana has had to deal with the worst increase of 106.9% while Ohio’s comes in at a much more reasonable 5.2%.
In fact, nationwide in 2022 the average cost for one year of education at a 4-year public college in the United States clocked in at $10,940 for in-state residents. By 2027 that figure is expected to be almost $12,500!
Parents of college-bound children are going to have to help pay for these rising costs somehow. College costs include everything from tuition, to fees and living expenses. Many families are putting their hope into scholarships and federal grants like the Pell Grant, but those grants have not been growing at the same rate as the costs to send your child to college. In fact, parents expect to help pay for 30% of their child’s higher education costs on average. The rest will have to be made up with financial aid, grants, and other scholarship funds. To apply for financial aid, you’ll need to fill out the Federal financial aid (or FAFSA form) each year.
Fortunately, there are many options available to those looking to save for that college degree. Some options available include savings bonds, playing the stock market and the lesser-known 529 plans. A recent 2022 study found that only 34% of Americans were even aware that 529 savings plans existed.
What is a 529 Plan?
529 Plans grow in a tax-free environment (i.e. you do not pay federal income tax on any growth), and generally have a 3-5% rate of return.
Starting a 529 account now is always the best option, no matter how old your child is. While utilizing the stock market may potentially yield higher returns on your initial investment, placing your money into a 529 plan is usually the safest option to pay for higher education. This is because while a 529 account grows in a tax-free environment, many states also allow parents to apply immediate tax deductions on the money put into these accounts. One study even found that when all the various tax benefits were taken into consideration, 529 plans still outperformed their benchmarks in just about every category.
There are also no age limits associated with the use of 529 plans – anyone can use them, including you.
How do you setup a 529 Plan?
Every US state has their own state sanctioned 529 plan available to their constituents. Usually with an initial contribution of less than $100, you can begin saving for your child’s education in any of your state’-managed 529’s qualified tuition programs. This includes both their own 529 plans as well as prepaid tuition. We have reports for each state that give you details on each of their 529 plans. In addition to these 529 and prepaid tuition plans, many financial companies such as Charles Schwab, Vanguard and TIAA-CREF have their versions of a 529 account. The only difference between the two types is where the fees are paid. Overall, they are similar enough to just pick one you are comfortable with and start saving immediately.
Parents can contribute up to $17,000 per year per person in a 529 plan in 2023 without incurring federal gift taxes, or they can save up to $34,000 if the parents are married and filing jointly. If parents have the funds, they can front load five years’ worth of 529 contributions all at once. Single people can put in up to $75,000 per child – or $150,000 if married and filing jointly – and write off the contribution from their federal taxes over the course of five years.
What Qualified Education Expenses Can You Use 529 Funds For?
The largest caveat of 529 plans is the fact that you can only use the funds inside these accounts on eligible education expenses. However, not all college expenses are covered. Here is a list of all qualified education expenses you can pay with a 529 College Savings Plan:
- College Tuition and Fees. Any post secondary educational institution that is eligible to participate in the federal student aid program is allowed.
- Vocational and Trade School Tuition and Fees. These types of schools include trade schools, community colleges, graduate schools and even some international schools.
- Elementary or Secondary School Tuition. The Tax Cuts and Jobs Act of 2018 opened up the use of 529 college savings plan funds at public, private, or religious elementary schools.
- Room and Board. On and off campus room and board is a qualified expense. The only catch is that off-campus housing and rental fees are covered up to the cost of room and board on campus.
- Food and Meal Plans. Meal plan for on and off campus students are allowed to be paid for by 529 funds.
- Books and Supplies. Any supplied required for classes are allowed, which include textbooks, pens, paper and more.
- Electronic Devices. Any electronics that are required by the college are covered. This includes laptops, iPads and calculators, but the catch is that they need to be required for enrollment.
- Computer Software. Just like with the electronics, if specific software is required for classes, then it is allowed to be paid for with 529 funds.
- Internet Services. 529 funds can be used to pay for internet access or ISP fees.
- Special Needs Equipment. If your child has special needs, then any services or equipment may be covered. This can include things like transportation and wheelchairs.
- Business Startup Purchases. If your child wants to start a business after graduation, some business equipment can be expensed if also used in the final years of college.
What is NOT a 529 Qualified Education Expense?
Unfortunately, not all college expenses are allowed to be paid for with a 529 savings account.
- Transportation. 529 funds cannot be used for car, gas, bus or airfare expenses, even if you need them to get to and from college.
- Sports and Extracurricular Activities. Fees for athletics, gym memberships, or school-sponsored groups or campus events can’t be paid with 529 plan funds.
- Health Insurance. Any medical expenses your child incurs while in school, and any health insurance premiums cannot be paid with a 529 plan.
What happens if your child does not go to college?
A major concern for anyone considering investing in a 529 Plan is what happens if your child does not go on to higher education after high school. While there is a 10% penalty for any non-qualified withdrawals, there are some creative ways to get around this restriction.
You won’t be hit with the 10% penalty if your child receives a scholarship, dies or enrolls in a US service academy instead. While you’ll still have to pay income taxes on any gains earned in these circumstances unless you pay for a qualified expense, it is still a favorable outcome.
If you have multiple children, you can also change the beneficiary of any 529 plan if one gets a scholarship or another exemption occurs. This means that if you are not in need of the money, you can always let it sit and gift it to another family member, like a grandchild.
You can also withdraw the amount of principal that you invested without penalty. This means that you can leave the growth in place to avoid being penalized.
Also added in 2022, you can now roll any unused 529 plan funds into an IRA.