Before you invest in any type of college savings plan, you should consider the advantages and disadvantages that it provides. The information below may help you as you consider using a 529 plan to build up college funds for your child.
The benefits of a 529 plan
Here are some great reasons to consider investing in a 529 college plan to save for your child's education:
529 plans are tax-deferred investments
When you invest in a 529 college savings plan, your withdrawals will most likely be tax free. (It's always wise to refer to IRS Publication 970 to be sure.) Until recently, this tax-free provision was set to expire in 2010, but, thanks to recent changes to the law, it appears to be a benefit that will be around for years to come.
Your account earns interest
529 plans work a lot like mutual funds. Some states' plans may operate differently, but most invest your money in stocks and bonds in the hope that it will grow faster than a regular bank savings account. Most plans do a pretty good job of managing your money.
However, you should be sure to research any plan you consider before you sign any investment contracts. Make sure you're comfortable with where the plan is investing your money, the investment's level of risk (conservative versus aggressive), and what the plan's recent performance was like. Decide what you can live with before signing on the dotted line.
An automatic investment option
Many plans offer an automatic investment option which allows the 529 college plan to withdraw a specified amount of money each month from your checking or savings account. You determine the amount and better yet, you get to enjoy hands-free investing that helps prevent you from spending your money on something else. With this option, you'll never need your checkbook to put money in your plan!
You can contribute as much as you want
College savings 529 plans allow you to put in as much money as you want per year. (Pre-paid tuition plans, unfortunately, do not. They limit the amount of money you can contribute per year, much like an IRA does.) While unlimited savings sounds glorious, be cautious not to paint yourself into a corner by saving too much.
Your money is portable
A college savings 529 plan allows you to transfer the money from state to state and to use the savings toward any college of your child's choosing. Both savings and pre-paid tuition plans can be transferred from family member to family member, so if one child decides not to attend college, you can use that money toward another child's tuition.
The drawbacks to a 529 plan
While there are benefits to using 529 plans as investment vehicles for college funds, there are some significant negatives to consider:
You must use the money for college
If you don't use the money you invest in a 529 savings plan for college tuition, you will be penalized 10 percent when you withdraw the money to use it for something else. In addition, both your state and the federal government will tax the earnings on your account in your current tax bracket.
If you have excess money in the account after all your children complete college, then that money may also be penalized and will definitely be taxed by both your state and the federal government. It's best to err on the side of underestimation. A good rule of thumb is to try to save an amount equal to the cost of four years of college at an in-state, public college.
It could affect your financial aid eligibility
Currently, financial aid eligibility isn't affected much by 529 plans (college savings plans or pre-paid tuition plans) because these plans are considered part of the parents' assets in the calculation of the Expected Family Contribution (EFC) toward college costs.
Your investment options are limited
Even though your 529 savings plan is tax deferred, you may give up the opportunity to change your mind about where to invest your money. What does that mean? Well, if you find a mutual fund that is making more in interest than your 529 plan and want to move your money, then you will be subject to the 10 percent penalty mentioned earlier.