Saving for your child’s college education is an important responsibility you have as a parent. An excellent way to help you achieve this is through a 529 account. A 529 account allows you to invest money for college education, and the earnings from those investments are not taxed. All 50 states and the District of Columbia allow you to invest money this way. It is a great opportunity for college savings; the only question is how to efficiently use these accounts.
Make Sure You Only Use Accounts for Education
The tax benefits for 529 plans only come into play when you use it to pay college expenses. If you use the money in your account for another purpose — such as paying debt or buying a house — not only do you have to pay taxes on the money you earned through your investment, but you will have to pay an additional 10 percent federal tax penalty. Be sure you only invest money you can dedicate to education, or know that you will suffer a financial setback later.
Gift the Money to Your Children
Generally, 529 plans are placed in the name of your children and contributions are considered gifts. The federal gift tax applies a levy on all gifts to a certain person over a given amount. This amount changes every year, although each individual can give up to a certain point. That means both parents working together can give up to two times the federal gift limit every year without triggering the gift tax. Prior to making any contributions to the account, make sure the amount you are going to invest for that year is less than that year’s tax-free gift limit and avoid that extra layer of tax.
Choose the Right Plan for You
There are two types of 529 plans:
- A prepaid tuition plan locks in tuition at a participating public or private college and covers fees and tuition only. Room and board can sometimes be covered by these plans, but not always. Investment plans are often guaranteed by the state.
- A college savings plan does not lock in tuition levels, but the funds can be used for tuition, fees, room and board, and other required expenses, such as books. There are no guarantees and the funds are subject to market risk.
While prepaid plans offer more protection from risk, they also greatly limit your options for schools. If your child absolutely knows where they want to go, a prepaid plan may not be the best option. If your child is undecided, a college savings plan may be the best choice.