My wife and I began thinking about college expenses when we were expecting our first child.  With college tuition rising faster than inflation, we know that saving for college is important!

My wife and I have started saving for our retirement and we have eliminated all debt except our mortgage, so we decided we should start planning for our children’s education costs. We researched several college savings opportunities, including 529 College Savings Plans and Coverdell Educational Savings Accounts (ESAs).

The 529 College Savings Plan is the most flexible and powerful way for most people to save for college. Let’s dive in and see why this might be a good option for you and your college planning needs.

What is a 529 plan?

A 529 College Savings Plan is a tax-advantaged college investment and savings vehicle designed to encourage parents and other family members to save money to help pay future college expenses. Like a 401K plan, the 529 plan gets its name from the section of the Internal Revenue Code that spells out the rules for its tax advantages, deferrals, and other information.

How Does a 529 College Savings Plan Work?

The 529 plan owner makes contributions to the account and can assign a beneficiary to receive the money once they reach college age. The plan and money stay in the owner’s name until the money is withdrawn by the beneficiary for educational expenses.

529 College Savings Plan Transferability

The assets held in your 529 plan can be transferred without penalties to another family member to use for their education. This means my wife and I can open accounts under our name and change the beneficiary to our child after he or she is born. We could also elect to use the 529 College Savings Plan for our own educational costs should we wish to.

Contributions and Withdrawals

Contributions are made with after-tax dollars, like with a Roth IRA. However, there may be certain tax benefits for 529 plans depending on which state you live in and in which plan you participate. Withdrawals from a 529 College Savings Plan is similar to a Roth IRA – the money that is withdrawn is tax-free if it is used for qualified higher education expenses. Qualified expenses generally include tuition, room, board, books, lab fees, and computers. Be sure to check your 529 plan for more details.

Types of 529 College Savings Plans: Prepaid and Savings

Prepaid 529 Plan

Some states offer prepaid tuition plans that allow parents to lock in tuition at current rates for any state college. The benefit is that you can start making fixed payments now to pay off college at today’s rates. By spreading it out over time, it is much more affordable. The disadvantage is that if your child goes to an out of state or private university, you may only receive a portion of the benefits you paid into. More on this topic below.

529 College Savings Plan

The 529 College Savings Plan is more flexible than the prepaid version. You control the money you deposit into your 529 Savings Plan and invest it in a portfolio of your choice. Depending on the state plan you join, you can invest in mutual funds, annuities, CDs, and more.

There are two main advantages of the 529 College Savings Plan. The first is that the savings can be used for tuition and expenses at any public or private college in the US, not just the state of residence where tuition was prepaid. The second advantage is you control where the money is invested, which may make it easier for you to grow your money above the rate of inflation.

Choosing a 529 Plan Type – Prepaid Tuition or Savings?

A prepaid tuition program can save parents a ton of money in saving for their children’s education. Unfortunately, many of these plans have recently experienced significant financial difficulty due to the rising costs of college tuition and the downward slump of the economy.

Which is it? Are prepaid college tuition programs a good or bad idea?

When Prepaid Tuition is a Bad Idea

Here are four risks you take with prepaid college tuition programs:

Assuming Your Child Will Go To College. 

First and foremost, these plans assume that your children will go to college. Because the future is unpredictable, it might be wiser to place your savings into a form that is more flexible and open to various possibilities. You could move out of your state or your children might decide to pursue a different path. This could leave you in financial difficulty down the road and unable to adequately fund what they want to do or where they want to go to school.

Assuming College Costs Grow According to Plan. 

Many of these plans are structured around the assumption that college costs will rise a certain percentage each year. In many states, the rate at which college costs are growing has now superseded expectations. This has led to severe financial difficulty with these savings plans being underfunded by millions of dollars. In fact some states have run out of funding altogether. The future of severely underfunded programs is unknown amidst a time of budget crunching by state legislations across the country.

Assuming Your Child Wants to Go to, and Can Be Admitted to, a Public Institution.

It’s important to note that these plans do not guarantee college admission, and they are generally geared towards public, not private education. So, in many ways, you are limiting your child’s college options. They might have a specific talent that’s better suited to develop at a private school, and if you purchased this plan for them when they were younger, they might be unable to go to their college of choice. Additionally, you might not need the funds at all if they end up with a scholarship that provides for their tuition or they decide not to attend college.

Assuming You’ll Get Your Money Back.

Some of these plans will only return your original contribution if your child decides not to attend college, so it’s extremely important to read the small print before you sign anything. It’s this reason in particular that many people have shied away from prepaid tuition plans.

When Prepaid Tuition is a Good Idea

However, with all of these drawbacks, there are some unique perks to saving with a prepaid college tuition plan.

Purchasing Future College at Current Prices. 

You are essentially purchasing future college tuition at today’s prices, provided your state’s funding remains intact. (How long underfunded programs is unknown; however, it would be politically unpopular to kill off programs that encourage students to go to school in-state.) Considering college costs are rising at rates well above inflation, being able to lock in your price today could be a huge financial payoff when your child reaches college.

Others Can Contribute to College Funding.

In many states, family members and friends can purchase credits towards your child’s tuition. This would be a great way for them to contribute to your children’s future on every birthday or major holiday. Of course, the biggest and most obvious perk is that with just a little bit of investment every month, you will have a significant portion of your child’s tuition taken care of by the time they reach 18. Many of these plans also allow this money to go towards books and living expenses, so they could also get help in those areas as well.

Final Thoughts on Prepaid Tuition Plans

Prepaid college plans were more popular several years ago prior to the major economic slump. However, many people still utilize them today, and there are thousands of students currently in college who benefited from them. It is important is that you assess the pros and cons very carefully for your own unique situation and discuss your options with a financial counselor. This will ensure that you make the best possible choice for you and your family.

How to Open a 529 College Savings Plan

Opening a 529 savings plan is very similar to opening any other financial account, such as a bank account, brokerage or investment account, etc. The only difference is you will often open the account on the behalf of the beneficiary. For example, when I open a 529 account for my daughter, I opened the account in my name and named her as a beneficiary.

Make sure you have the personal information available before opening the account – name, date of birth, social security number, etc. You will also need to bank account and routing number if you plan on making an ACH transfer to fund your 529 account when you open it.

How to Find the Right 529 Plan for Your Needs

As mentioned earlier, there are two types of 529 college savings plans – prepaid, and savings. So you will want to make sure you are keeping this in mind before opening your 529 plan. It is also important to understand you are not limited to the plan in your state or at your local university.

Some important factors to consider are:

Fees. Consider any fees and drawbacks before making your final decision. In some cases, it is worth it to pay a professional who is well versed in this area of savings, while in other cases a well-informed investor can save these expenses by going it alone.

Tax deductions. When deciding if you are going to invest money in the state in which you reside, consider there are often many benefits of sticking close to home. If you are able to deduct your contributions in your state or if you live in a state that has high-income taxes, it might be more beneficial to keep your money within your state borders. Again, this is an area where you must do your homework to make sure you are not missing out on any benefits or incentives extended to individuals who invest in the state of their residence.

Investment options. You also need to consider which investment options are available to you. Investment options vary widely since each 529 plan is run by individual states. Some states offer a wide range of low-cost mutual funds, CDs, and other investment options, while other states have a narrow selection, some of which might have high fees or may not be appropriate for short-term savings. Many states may offer a plan they run, as well as a plan run by a brokerage firm. Be sure to investigate all options.

Shop other states. If your state’s plan is not as lucrative as you would prefer, there are out of state programs that combine low expenses with flexible investment options and appropriate risk management. Your final decision should really be based on how affordable the plan will be as well as what types of benefits that particular plan offers to you and your family.

Where to Open a 529 College Savings Plan

There are several choices for opening a 529 College Savings Plan: Within your state, in another state, or directly from a university. Many states offer a plan they run, and several states offer a plan run by a brokerage firm.

The difference between the two usually boils down to investment options and fees. Many states also offer both the prepaid and savings version. College-run 529 plans are usually of the prepaid variety (advantage: possibly lower rates; disadvantage: you are locked into one university).

If your state offers income tax deductions on your contributions, you may wish to go with your state 529 plan because you will probably save money in the long run. However, if your state doesn’t offer tax deductions, or if they do but the fees are too high, then you should consider either opening your 529 plan in another state or using a broker to manage your 529 plan.

The added benefit of using a brokerage firm is the wide range of investment options available to you, though there may be higher fees. One of my recommendations is the Ohio College Advantage 529 Plan, which is always rated among the best 529 plans by state, according to Kiplinger.

What To Do With an Unused 529 Funds

For many parents, the spring semester of their child’s senior year of high school is all about college planning. And those with a fat 529 account set aside for Junior’s education might be feeling nothing but excitement for the next chapter in their child’s life. But what if your child drops the bomb that he wants to work for a few years or join the military instead of going to college? What can you do with the money you have carefully set aside for his education?

Just withdrawing the money might not be the best idea. Using the funds for anything other than qualified education expenses means that you pay taxes at your rate on the earnings (which would otherwise be tax-free) plus a 10% penalty.

Common Reasons for Unused 529 Funds

Here are some options for that unused 529 account depending on which circumstances you face:

1. Your child earned a full scholarship. Congratulations! You have a couple of options available to you in this scenario. You may roll the account over to another family member within the same generation. The plan defines a family member as any of the following: “the original beneficiary’s spouse, children, sisters, brothers, nephews, nieces, first cousins, and any spouses of those persons.”

So even if you know that Junior’s little sister is also likely to earn a major scholarship, you have plenty of family members to choose from in terms of passing the money along.

It is important to note, however, that if the beneficiary is of another generation (i.e., a child of the original beneficiary), then there could a gift tax liability on the rollover. If you are going to make an inter-generational beneficiary change, make sure you talk to your financial adviser about the best course of action.

If rolling over the 529 isn’t a possibility, you can also cash out your account with no penalty other than the tax paid on earnings.

2. Your child doesn’t want to go to college right now. 18 is awfully young to know for sure what you want to do with your life. Some kids benefit from a few years of working and learning about themselves before going to college. If your child wants to hold off for a few years—but definitely wants to go to college eventually—then you can just sit tight on your 529 account. Most states do not impose an age or time limit for use of the money. (Some do, so it is important to know which plan you have). No age limit is one of the reasons why 529 plans are more flexible than Coverdell ESAs.

Your funds will continue to grow—without being taxed—until your child is ready for school.

3. Your child doesn’t want to go to college at all. While education can really help your child to grow his career, it certainly isn’t for everyone. If Junior has decided to go in a different direction and is absolutely certain that he won’t change his mind, you can roll the plan over to another beneficiary.

4. You saved too much. If only we all had this problem! But if you did save more in your 529 account than your child needs in order to get her education, you can leave the money in there for graduate school, if your child decides to continue her schooling, or can roll over the funds to another beneficiary.

5. Your child is unable to go to college. If your child becomes disabled or passes away before beginning his higher education, the money can be cashed out with no penalty other than the tax on earnings.

Finally, when it comes to 529 plans, remember that the definition of qualified education costs includes such things as tuition, room, board, transportation, books, and even necessary equipment like laptops. There are plenty of opportunities to use that money for qualified expenses.

529 Plans Offer Flexibility and Tax Advantages

The 529 College Savings Plans is a great way to start saving for college. There are certain tax advantages to 529 plans which will be covered in a later article and the option to transfer the money to another beneficiary is an added benefit. 529 Savings Plans are also widely available: each state offers a 529 plan, but you are free to choose which plan you wish to open. If you are saving for your children’s education, I encourage you to do more research into 529 College Savings Plans.

More college savings articles:

• Coverdell Educational Savings Accounts (ESAs).
• Coverdell ESAs compared to 529 Savings Plans.