Smart Saving for College

College Savings Options

 

Common Features of Prepaid Tuition and College Savings Plans


Federal Tax Advantages
Among the biggest advantages of 529 plans over other college savings options are the tax advantages they offer. Earnings grow tax-deferred and withdrawals are tax-free when used for qualified education expenses.

Although the IRS typically allows you to give no more than $13,000 a year to another person without a federal gift tax, you can contribute up to $65,000 to a 529 plan in one year. A special tax law allows you to aggregate five years of the allowable $13,000 annual gift-tax exclusion to jump-start a 529 plan. While you will be precluded from making any further gifts for five years, compounding will make your earnings grow faster than if you invested $13,000 in each of the five years. Use our College Savings Calculator to see the difference in savings of using a lump sum to jump-start a 529 plan.

Also, anyone can contribute to a 529 plan. Unlike education savings accounts (ESAs) and saving bonds, which are discussed later, there are no income limitations. For most wealthy families, 529 plans are one of the few available tax-advantaged college savings options.

State Tax Advantages
State tax treatment of 529 plans varies from state to state. In 34 states and the District of Columbia, contributions are tax deductible if you're a resident of the state sponsoring the 529 plan. In five of those states—Arizona, Kansas, Maine, Missouri and Pennsylvania—you can claim a state tax deduction for any 529 plan, regardless of its location. The amounts you can deduct also vary. Colorado currently allows residents to deduct the entire amount of their contribution to their in-state plan for each beneficiary, up to the amount of their annual adjusted gross income. Rhode Island, on the other hand, allows only a $1,000 deduction in total for joint filers and $500 for single filers. Many states also follow the federal tax lead of allowing earnings to grow tax-free and imposing no state tax on qualified withdrawals from in-state and out-of-state plans.

A few states offer scholarships, grants or matching contributions for low and moderate-income families. The Florida Prepaid College Foundation offers a limited number of needs-based scholarships, and North Dakota offers a matching grant of up to $300 to participants meeting the state's income requirements. Go to the College Savings Plans Network to compare plan benefits by state.

Control
Unlike custodial accounts and ESAs, 529 plans allow the account owner to maintain control over the assets in a 529 plan for the life of the account. You also can change beneficiaries to another "family member" of the original beneficiary. Thus, if your child gets a scholarship or decides not to go to college, you can name another beneficiary—even yourself. Some 529 plans, especially prepaid tuition plans, may limit or restrict your ability to change beneficiaries, so check the plan offering document.

Transfers
The assets of one 529 plan can be transferred tax-free to another 529 plan of another beneficiary, as long as the new beneficiary is a "family member" of the beneficiary of the 529 plan from which the transfer was made. "Family members" include, among others, the beneficiary's spouse, son, daughter, grandchild, niece, nephew and first cousin.

The assets of one 529 plan also can be transferred tax-free to another 529 plan for the same beneficiary. However, only one transfer of this type is allowed within any 12-month period. There also may be state tax implications when you transfer from one 529 plan to another. You may want to consult with your tax adviser before you make a transfer.

Withdrawals for Non-College Related Expenses
If your child decides not to go to college or you over-fund a 529 plan, you may pay a penalty in addition to any taxes you owe on earnings. If you withdraw money from a 529 plan that is not used for qualified education expenses, you are generally required to pay income tax and an additional 10-percent penalty on earnings.

There are a number of exceptions to this penalty. The penalty may be waived if your child gets a scholarship or is disabled. You also can avoid the taxes and penalties by transferring the 529 plan to another beneficiary who will use the funds for qualified education expenses. Furthermore, you can use our College Savings Calculator to estimate the amount you need to save so that you don't overfund a 529 plan.

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