Contents
College Savings Fundamentals
How Much Will College Cost?
Prepaid Tuition 529 Plans
State 529 College Savings Plans
Private 529 College Savings Plans
Coverdell Savings Accounts
College Savings Withdrawals
How to Choose a College Savings Plan
Alternatives to College Savings Plans
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- The types of college savings plans and the unique features of each
- The specific college savings plans that are available in your state
- How to enroll in the plan that suits you best and start saving right away
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College Savings Fundamentals
College savings plans are tax-advantaged investment accounts designed to make it easier to save for college and other education-related expenses. This guide covers all the various types of plans offered by state governments, college consortiums, and financial services firms—including one of the most popular options, 529 plans (which are named for the section of the U.S. Internal Revenue Code that established them).
The Benefits of College Savings Plans
There are two major benefits of college savings plans:
- Tax savings: Investments made in qualified college savings accounts grow tax-deferred, which means you don’t pay federal taxes (and some state taxes) on dividends and capital gains (profits) that you receive before you withdraw any money from the account. If you withdraw money for certain qualified education-related expenses, your investments are also tax-free, meaning you don’t even pay tax upon withdrawal. Since investments in standard, taxable accounts are taxed at rates ranging from 15–35%, the potential tax savings that college savings plans offer is substantial. One major catch: if you withdraw money for purposes other than qualified education-related expenses, you’ll pay taxes plus up to a 10% penalty on your withdrawals.
- Prepayment of tuition: Some college savings plans allow you to pay for college at today’s tuition rates, even if the beneficiary of your account—the person going to school—won’t attend college for years or even decades. Since tuition costs for higher education are rising at rates that outpace inflation, paying tuition early can save thousands of dollars.
Though the tax benefits of some college savings plans were originally scheduled to run out in 2010, the Pension Protection Act of 2006 made these plans—along with their tax advantages—permanent.
Why Invest in a College Savings Plan?
Beyond the advantages of tax savings and tuition prepayment, there are two common-sense reasons to begin investing in a college savings plan as soon as possible:
- Higher education costs are rising rapidly.
- A college education is very valuable in today’s work environment, and likely even more so in the future.
The Increasing Costs of Higher Education
According to the U.S. Department of Education, over the past decade college tuition costs have risen 51% for four-year public schools, 36% for four-year private schools, and 26% for two-year public schools. These numbers suggest that your money must grow by about 5% every year just to keep up with the rate of tuition increases. College savings plans can help you meet or exceed these rates by deferring (or eliminating) taxes on your investments and by allowing you to pay tomorrow’s tuition at today’s rates. If you leave your money in a savings account—which typically earns just 1–3% per year—the rate at which your money grows won’t keep up with the increasing cost of higher education.
The Value of a College Education
In today’s work environment, having a college degree vastly increases your earning power, the salary you can expect to make each year. Full-time workers with college degrees earn an average of $19,900 more annually than full-time workers with high school diplomas only—which adds up to hundreds of thousands of dollars in earnings over a lifetime.
Many people make the mistake of thinking that a college education isn’t worth the expense, but as the statistics show, a college degree can quickly pay for itself.
Who Can Invest in College Savings Plans?
Though most college savings plans are set up by parents or grandparents on behalf of their children or grandchildren, any adult can set up a college savings account for any beneficiary. You can even set up college savings plans in which you yourself are the beneficiary—in other words, you can use these plans to save for your own education, whether for a college degree, an advanced (graduate) degree, or another qualified educational program.
College Savings Contributions and the IRS Gift Tax
Normally, the IRS imposes a gift tax on any monetary gift one person gives to another in excess of $12,000 in a given tax year. If the gift is a contribution to a college savings account, though, the IRS allows an individual to give up to five years’ worth of gifts tax-free in one year—which means that an individual can gift $60,000 worth of college savings at once to a beneficiary without incurring any tax liability.
The Types of College Savings Plans
There are four main types of plans used to invest money for higher education–related expenses. Though all of these plans are often referred to collectively as “College Savings Plans,” there are actually various different types of plans:
- 529 plans: These plans include 529 savings plans, prepaid tuition 529 plans, and private 529 plans.
- Coverdell Education Savings Accounts (ESAs): These accounts can be used for tax-deferred investing for qualified education-related expenses.
The most notable difference between these plans is whether they allow plan owners to invest money in tax-deferred accounts or to buy tuition at favorable rates. Plans also differ based on the institutions that offer them: some plans are offered primarily by state governments, whereas others are offered by commercial institutions, such as banks and financial services firms. Though many college savings plan owners choose one plan and stick with it, it’s also possible to use a combination of plans simultaneously to accomplish your college savings objectives.
This guide covers the various types of 529 plans, as well as Coverdell ESAs. Though this guide focuses on how to use college savings plans to fund college-related expenses for your child or children, you can also use it as a reference for college savings planning for your own higher education or for that of other beneficiaries, such as your grandchildren.
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