This article is a guest post written by Charles Donalies, founder of Donalies Financial Planning. Charles and I became friends after meeting at the XYPN conference and I asked him to write some thoughts on starting a 529 plan as a guest topic for this site.
A 529 plan is an investment plan that allows you to save for college and offers several benefits over a traditional savings or investment account.
Before you start one, here are twelve things you should know. Read them carefully and you’ll probably make better decisions about setting one up for yourself or someone you care about.
1. 529 Plans Help You Save Money on Income Taxes
Some say the best reason to open up a 529 plan is the tax savings. The plans were named, after all, after the IRS tax code that dictates the rules and regulations under which these plans were created.
529 college plans are investment accounts, but unlike traditional investment accounts, your earnings aren’t taxed. That means the annual capital gains won’t be added to your taxable income on your federal and state income tax returns.
That holds true whether you’re using the funds or not- each year as the earnings accumulate, there are no taxes on them. And then once you begin using the funds for education, they are still not taxed… never!
2. The Sooner You Start a 529 Plan, the More You Benefit
Since 529 college savings plans are investment accounts, the principles which dictate how to invest successfully in any investment account also hold true for the 529s.
That is: an early start is advisable. That way, your investments have time to not only accumulate but also recover from any market downturns that eventually do occur.
3. ‘How Much’ is Less Important Than ‘When’
Getting started sooner rather than later is more important than how much you can actually afford to contribute, at least at first. Even if you only have $50 per month at first, start one anyway and let that money start working for you by accumulating earnings in the market.
Later on, when you can afford to increase your contributions, you can step up the savings and really begin to build up that account.
4. Starting Early Can Add Up to Thousands in Tax Savings
So far you’ve learned that starting early is good, and that the beauty of a 529 plan is the tax savings. Now consider this: those tax savings can add up to a lot of money: thousands, even. The key to locking in those savings for yourself is starting early.
5. The Tax Break is for Everyone
Many tax breaks disappear once your income gets above a certain amount. An example of this would be the Roth IRA, which locks out savers once they make too much money.
Not so with the 529 plans. You can make a billion dollars per year and still enjoy the income tax benefits that come with a college savings plan.
6. Almost Every State Runs a Different 529 Plan
529 plans are administered state-by-state, and each state seems to do it differently. Some states have more than one 529 plan, too. That means you’ll have to refer to your state’s rules when opening up your plan, to make sure you’re getting the right plan.
7. You Can Invest in Any State’s Plan
If you want to, you can start a 529 in a different state from where you actually reside. People who choose this route usually have in mind some sort of agenda that involves the benefactor (the future student) attending college in that other state.
Choose carefully, however, since it’s a general rule that the income tax deduction is usually better when you invest in 529 plans in your own state.
8. Every State Runs its Plans Through a Single Administrator
Every state chooses a financial company to run its college saving plans. Some states use Vanguard, for example, so you’d go through them to open up your account.
9. You Also Have the Option of Opening Your Plan Through an Advisor
To open up your account, you may contact directly the financial institution that manages 529 plans in your state. Alternatively, if you would like more support in way of advice and services, you may also open up an account through a financial advisor.
He or she will not only help you choose a plan that best fits your goals, but will also administer the plan for you once it’s been opened and started.
In addition, financial advisors can help you with the big picture, too. That is, they can help you take stock of your entire financial world, offering you a detailed analysis of your financial snapshot. That can help determine how much to invest in your 529 plan each month, and how that amount should change over time as your finances change, too.
10. 529 Plans Won’t Affect Your Ability to Get Federal Financial Aid
Sure, a 529 plan increases the amount of money you have to contribute to either your or your child’s (or grandchild’s) education. However, contrary to what many people mistakenly believe, it doesn’t affect eligibility for financial aid.
There’s no real financial aid penalty for saving in a 529 plan, since the federal rules for eligibility expect parents to contribute under six percent of the plan balance each year.
What’s more, financial aid packages have more to do with your income at the time of the student’s attendance at college, not when you start the plan.
11. You Will Owe Taxes if You Misuse 529 Funds
Those tax advantages we mentioned earlier will be whisked away pretty quickly if you use the money from your 529 account for unqualified expenses. Plus, you’ll be slapped with a ten percent penalty payable to the government. Keep that in mind when it comes time to start withdrawing, and make sure you know the rules.
The only way out of these taxes and penalties is if the benefactor student becomes disabled, dies, or wins a scholarship, in which case the funds won’t be needed.
12. It’s Virtually Impossible to Stash Away Too Much in a 529 College Savings Plan
Worried you’re putting too much in your 529? College is expensive, and even if you don’t use it all, the extra can be used for graduate school. You can also switch the beneficiary, if you want. Most plans allow a change once a year.
That means the money that’s left over after your first-born finishes college can be used for his or her younger siblings. Or just let it sit there for the next generation!
About the author: Charles Donalies is the founder of Donalies Financial Planning, a fee-only financial planning firm located in Washington, D.C.