529 Plans: As a Way to Save for College, They're Consistently Head of the Class
Of all the investment options designed for college savers, one type offers the best mix of tax benefits and flexible investing options: a 529 plan.
According to the College Savings Plan network, the amount invested in 529 plans reached a new record of $227.1 billion in 2013. With half a million accounts opened in 2013 alone, the number of 529 plan accounts outstanding hit 11.6 million, meaning that the average 529 balance rose to a record $19,584.
The Basics of the 529
The easiest way to understand a 529 plan account is by comparing it to an investing option you're probably already familiar with: a Roth Individual Retirement Account. With a Roth IRA, you make your contributions with after-tax money, and the balance grows tax-free while it stays inside the account. When you withdraw money from a Roth IRA in retirement, the proceeds are also tax-free, giving you a big benefit over a regular brokerage account without special tax benefits.
Similarly, 529 plans don't give you a federal tax deduction when you make your initial contribution. But once the money is inside the 529 plan account, any income and capital gains are tax-deferred. As long as you eventually use the money you save in a 529 plan for qualified educational expenses -- things like tuition, required fees, books, supplies and even room and board for students enrolled half-time or more -- then you won't have to pay tax on distributions you use for those expenses.
Some states' college savings plans offer other incentives. For instance, Ohio offers participants a state income-tax deduction of up to $2,000 for contributions.
The 529 accounts have another advantage relating to financial aid: They're generally treated as parental assets rather than assets owned by the child. Here's why that helps you. When calculating what families are expected to contribute, the maximum amount of parental assets a college will consider is 5.64 percent. The maximum amount of the student's assets? 20 percent. That means a smaller percentage of 529 plan balance will be counted, minimizing its impact on your child's financial aid package. And some states are even more generous, choosing not to consider 529 plan assets at all in determining eligibility for state aid.
By contrast, custodial accounts are generally treated as belonging to the student for financial aid purposes, and tapped at the 20 percent rate when considering available financial resources.
From an investing standpoint, 529 plans aren't perfect, but they are still attractive. Unlike the rival Coverdell Educational Savings Account, 529 plans only offer limited menus of mutual funds, exchange-traded funds and other investments like bank CDs. But with plans from all 50 states -- and with only a small number limiting participation to state residents -- college savers have dozens of options to avoid inferior plans with high fees and bad performance.
Finally, most 529 plans allow you to save much more than Coverdells. The 529 contribution maximums in many states exceed $200,000, while the limit for Coverdells is $2,000. Even if you make a Coverdell part of your college savings strategy, you still have room to use a 529 plan as well.
You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google Plus.