September 13, 2008

Using a 529 plan to save for college

The other day I talked about Our plan for paying for college costs. Who pays? How much? and I briefly mentioned that I plan to use a 529 plan to save for our children's college.

529 plans are tax sheltered savings plans specifically for saving for college expenses. The earnings in your 529 plan are exempt from federal tax and usually free from state taxes. The main reason to go with a 529 plan is the tax benefits.

529's aren't the only vehicle that could be used for saving for college.

What are the college savings options?

529 plans - They give tax sheltered benefits, they place the funds under the name of the plan owner for purposes of financial aid calculation allows, you to change beneficiary, intended to be used for college only, controlled by contributor, possible state tax deduction, federal tax and 10% penalty for early withdrawal.

Education Savings Accounts (ESA) - Up to $2000 a year, use for K-12 as well as college, puts funds in contributors name for financial aid, controlled by contributor, no state tax deduction, income limits, federal tax and 10% penalty for early withdrawal.

UGMA/UTMA accounts - Considered asset of child, used for any expense to benefit child, no penalties for withdrawals.

Standard savings vehicles - You could alternatively simply invest your money in savings accounts or mutual funds. This option has no tax benefits but you have full freedom on how you use the funds.

The 529 appears better than the ESA to me. The 529 has all the same benefits but the ESA has some other limitations. The UGMA/UTMA accounts are considered as assets of the child which has a greater impact on financial aid qualification, plus theres no special state tax benefits for those. Among these choices a 529 account is my pick.

Vanguard has an evaluator to help you pick what kind of college savings vehicle is best for your circumstances. For me the 529 plan was what Vanguard recommended.

If you figure that a 529 account is your choice then you can next investigate the available 529 options. Generally it will be best to go with the 529 plan offered by your own state so you can take advantage of state tax benefits.

You can go to the CollegeSavings website and find information on 529 plans. From the main page if you select 'My States 529 plan' and then select your state it will take you to the specifics on your states 529 plan(s). My state has a few choices. One is two of the plans are 'advisor sold' and the third option is 'direct sold'.

Make sure to compare the maintenance fees, expense ratios and investment options when you are looking at 529 plan choices. If one 529 plan has a $50 annual fee and 1.5% expense ratio and 11 investment choices and another plan has no annual fee, 0.8% expenses and 25 investment choices then the later choice would be the obvious one.

Some states will have 'prepaid tuition plans'. With these plans you can pay a specified amount today and have a year or unit of tuition prepaid in advance. The prepaid plans guarantee you a locked in price but they are meant for use with colleges in the state of residence only so they may lack some flexibility if you're locked into the schools in your state.

You don't have to go with your own states plan. If your state plan has poor choices, high fees or other negatives then you could enroll in another plan. For example, the is a prepaid tuition plan for 270 specific colleges.

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