The Easy Way to Pay for College 73% of Americans Aren't Using

By Markets Fool.com

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Source: Taxcredits.net via Flickr

If you're planning to send your kids to college, there are several great options available to you that can help you save. Of these, a 529 plan is perhaps the easiest and most flexible choice for most families. Unfortunately, a recent study shows that two-thirds of Americans have never even heard of a 529, and just 27% of families use a 529 to save for college.

If you're one of the millions of Americans who are unfamiliar with the 529 plan, here's what it is and how it can help you send your kids to college for less than you may think.

What is a 529 plan?
A 529 plan is a tax-advantaged account intended to allow parents (and other friends/relatives) to set aside money to cover higher education expenses. And, the plan comes in two main varieties: prepaid and savings, both of which are issued by individual states.

A prepaid 529 is designed to allow parents to "prepay" tuition expenses for an in-state public college at the current rate. Participants buy "tuition credits," so the intrinsic value of the plan grows along with tuition. In other words, if tuition is increasing at 5% per year, so is the value of the tuition credits you purchased.

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If your child doesn't end up going to an in-state public school, the value of the plan can be transferred to an out-of-state or private school, but there may be a charge for doing so. There are only 10 states that are currently accepting new applicants, so the savings plan is the more common option.

A 529 savings plan works similarly to a 401(k) plan in terms of its investment style, and is good for any accredited college in the U.S., regardless of which state issues the plan. You contribute money and choose how you want your money invested (aggressively, conservatively, etc.). And the value of your investments depends on the performance of the funds you choose.

In general, 529 savings plans offer two types of investments. The first are known as "static options," meaning that you choose a fund or certain risk profile, and your investment choice stays the same unless you change it. Additionally, most plans offer age-based options, which start out with aggressive growth investments and gradually adjust to more conservative investments as the beneficiary approaches college age.

Finally, there can be major differences in rules, fees, and investments between different states' 529 savings plans. For example, some plans only allow in-state residents to participate, while others are open to residents of any state. Furthermore, some 529 savings plans are purchased directly, while others are advisor-sold.

The benefits of a 529
There are many potential benefits to enrolling in a 529 plan. These include:

  • Federal tax breaks -- Your contributions aren't deductible on your Federal taxes, but your money grows tax-free, and you won't pay any taxes on the money you withdraw to pay for education expenses.
  • State tax breaks -- 34 states offer some sort of tax breaks for participating in a 529 plan, so check your state's policies. Many states allow for contributions to 529 plans to be deducted, even if the contributions were made to another state's plan.
  • Easy investment choices -- Basically, you just choose your investment funds, contribute money, and the plan does the rest.
  • High limits -- Lifetime contribution maximums range from $235,000 to $400,000, depending on the individual plan.
  • Flexibility -- If your child doesn't go to college, you can roll the money over into a 529 for any relative without any penalty (sibling, parent, cousin, etc.)
  • Universal eligibility -- Unlike many other retirement plan types, there is no income limitations to be able to contribute to a 529.
  • No tax reporting -- As long as your contributions are less than $14,000 per year ($28,000 from a married couple), there are no tax reporting requirements. (Higher contribution amounts may trigger the gift tax)

Save more than 50% on your child's tuition
As a simplified example, let's assume that you have a newborn child, and your goal is to save enough to send him or her to an in-state university for four years. Estimates on future college costs vary depending on which experts you ask, but according to a calculator by collegesavings.org, you can expect this to cost $110,427 including room and board, assuming a 2% annual inflation rate.

This may sound like a lot of money (and it is), but this is where the magic of 529 plans works for you. Assuming that your investments average a 7% annual return, you would need to set aside approximately $2,950 per year (or $246 per month) to end up with this amount.

So, over the next 18 years you'll contribute $53,100, or 52% less than the actual cost of sending them to college.

Of course, this is a simplified example, but the same idea applies to any particular savings goal. And, bear in mind that the more you save early on, the better the "discount" will be.

How to choose a 529 plan
There are a few things you should keep in mind when choosing a 529 plan

  • Tax benefits -- It's usually a good idea to start your search with your home state's plan, as it's the most likely to provide you with state tax incentives. For example, in my home state's direct-sold 529 plan, all contributions are deductible on your state tax return.
  • Fees and expenses -- Using this directory at Savingforcollege.com, you can find the details of any 529 plan, including the fees and expenses associated with the account. Lower fees are obviously better, and direct-sold plans seem to have lower overall expenses. However, these costs vary widely among plans, so it pays to do some research.
  • Investment options -- Most 529 plans have a similar assortment of investments to choose from, but it's still a good idea to look. If you don't want to worry about changing your investments over time, make sure your plan offers age-based investment options, which automatically adjust as your child gets closer to college age.

Early and often
If you have a young child, college may seem like the distant future, but that's the point. Just like saving for retirement, the sooner you get started the easier it will be. Not only do you have more time to save, but your savings have more time to grow.

So, whichever 529 plan you end up choosing or what particular investments you choose within the plan, the most important factor in your long-term success with the plan is contributing often and starting as early as possible.

The article The Easy Way to Pay for College 73% of Americans Aren't Using originally appeared on Fool.com.

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