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Guide to 529 plans: Here's what you need to know

A 529 plan helps you save for college. Here's a guide to how they work.

One of the biggest factors that determines where and when students go to college is cost. In fact, 67 percent of families consider the price of a school when making a decision, according to the 2016 Sallie Mae study, “How America Pays for College.” One of the best ways to ensure students have flexibility in choosing a college is to save for it. Of course, there are other options to fund your child’s education, but the earlier you begin to save, the more time there is to build up the savings, and the less you will have to worry about it later. One way to save for college is by investing in a 529 plan.

A 529 plan, also known as a “qualified tuition plan,” is a tax-advantaged education savings account operated by a state or financial institution. Tax-advantaged means that earnings are reduced or not subject to federal tax. The 529 plan allows anyone 18 or older to save for future college expenses. This plan was formed by Congress in 1996 to follow Section 529 of the Internal Revenue Code and it is regarded as one of the best ways to save for college because of the tax benefits, including tax-free earnings and withdrawals, and tax-deductible contributions deposited into the account.

There are two types of 529 plans:

Prepaid Tuition Plan

This plan is also referred to as a “guaranteed savings plan” because account holders are able to prepay for tuition credits at colleges and universities at the current rate of tuition. That means when tuition goes up in the future, the account holder pays the tuition price that was set the year that the savings account was opened. There are currently 11 states offering these plans nationwide. It’s important to note that you don’t have to set up the account in the state where you live. While locking in a tuition price might seem appealing to some, some consider it risky because money invested into prepaid plans can only be used toward tuition at the institution where the money is being invested. This means that if your teen doesn’t end up going to that school, they can’t use the money.

College Savings Plan

The college savings plan works much like a 401K or Individual Retirement Account (IRA). It’s an investment into a variety of mutual funds sold by financial institutions like Fidelity, Vanguard, TIAA, and others. This type of plan grows tax-free, meaning that you don’t have to pay taxes on the gains in the investments. However, it can be riskier than the prepaid plan because if the investment goes down, you could lose your money. If you do experience a loss, it is possible to claim that on your taxes. There are several investment options for the plan, and because of that, funds in the account can fluctuate based on your selection. When it comes to saving for college and investing in these plans, earlier is better. Money in 529 plans grows with compounding interest that will be returned annually. That means that interest is doubled because it is calculated based on the initial amount of money you invested into the account. Therefore the earlier you invest into the plan the longer your money has to grow.

Qualified expenses covered in the plan include tuition, room and board, books, supplies and equipment. For a complete breakdown of qualified expenses as regulated by the IRS, visit their website.

Before you select a plan, shop around and compare what works best for you. Here are some of the things to keep in mind as you consider which savings plan is best for you:

  • Consider the initial investment amount. There is a required minimum amount to open an account, some as low as $25
  • Search for plans by state. You can set up an account in any state regardless if you live there or not. While there may be incentives to enroll in your state, it is best to shop around for the plan with the lowest rates. Here is a database created by U.S. News & World Report which allows users to compare 529 plans nationally
  • Pay attention to annual fund and mutual fund fees. They can range from 0.2% to 7%. It is best to select a plan with low fees so that you can have a better return on your investment

Once you have selected a plan it is important to note that account holders can invest up to $14,000 a year per child without having to pay for a gift tax. Up to $300,000 can be invested into the plan over the lifetime of the account. It’s important to keep this in mind because money saved within the accounts are considered assets and can impact how much financial aid a student is able to receive once it is reported on their FAFSA.

There are even more benefits that come with 529 plans, such as:

  • Family and friends can make contributions to the account
  • The account beneficiary can be changed at any time. Qualifying beneficiaries include family members who are foster children, adopted children, spouses, cousins and in-laws
  • Section 541(b) of the Bankruptcy Code protects 529 plans from bankruptcy for people who deposited money into the account a year prior to filing for bankruptcy.

To find out more about 529 plans for college savings, ask a financial advisor or begin your search online.

Parent Toolkit resources were developed by NBC News Learn with the help of subject-matter experts, including Mark Kantrowitz, Publisher and VP of Strategy, and Brian Page, Educator and Financial Literacy Leader, Reading Community School District.