How to Save for a College Education – 529 Plan Basics

College costs keep rising.  Even amid our current economic crisis the cost of a college education is expected to grow.  So what’s a parent to do?   Clearly, establishing savings early and adding to it often are the keys.  The government has created a program, called a 529 Plan, to allow your savings to grow tax free, and to allow for tax-free withdrawals for “qualified higher education purposes.”  These benefits can help you reach your goals much quicker than with a traditional savings account.

So what is a 529?  It is named after Section 529 of the IRS code (clever, huh?) which defines the tax treatment.  529 plans allow anyone (parent, grandparent, aunt, uncle, friend) to invest for a child’s college education, and provided the money is used for higher education expenses, the investment earnings are tax-free.

529 plans are established by states, and each of the 50 states sponsors at least one plan.  Most states allow for some income tax deductions of the contributions made into a 529 if you also live in the state.  For example, if you live in Illinois and make contributions to the Illinois 529 plan, those contributions are deductible on your Illinois income tax return – but not your federal return.  If you live in Illinois and contribute to an Indiana sponsored 529, you cannot deduct your contributions on your Illinois return.   Deductible amounts vary by state, so it’s important to check with the state where you reside.   Currently California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota and New Jersey do not offer state tax deductions.  Alabama, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have no state income tax and thus offer no deductions.

So what can you use the money for?  The rules are actually quite broad:  distributions from a 529 plan can be used for tuition, fees, books, supplies and equipment required for study, and in many cases for room and board.  If your 529 is sponsored by one state, it does not necessarily mean your child must attend higher education in that state.   Funds can be used at any accredited college, university or vocational school in the United States and at some foreign universities.

529 Plans are simple to establish and most will allow small monthly contributions.  The first step is to investigate the plan your own state sponsors, to take full advantage of any tax deductions.  If you live in a state that does not allow deductions, you are free to choose any state’s plan.  Most accounts can be opened online and have age-based allocations.   You’ll want to be more aggressive with your investments for a 2 year old than you would for a 16 year old.

Finally, it’s important to remember that it is not your obligation to pay for your childrens’ educations.   Creating a savings plan and helping them where possible is great – but it shouldn’t be done at the cost of your own retirement.  There are low-interest government-sponsored loans available to students, and a college-educated child will have the earnings potential to pay these back over time.  Don’t neglect your own future.