The Smart Way to Save for College

By Alicia Rose Hudnett Markets Fool.com

You may have heard some financial pundits say that your children can get loans for college, but you can't get a loan for retirement. They're technically correct, and they're right to advise you not to forgo retirement saving in favor of paying your kid's tuition. Nonetheless, many parents want to do everything they can to help their children pay for a college education.

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Similar to saving for retirement, saving for college can take substantial sums of money and an early start, as college tuition has risen faster than inflation for the past several decades. And just as there are various tax-advantaged retirement plans, there are also tax-favored college savings accounts. One of these is the 529 account, which is named after Section 529 of the Internal Revenue Code and is meant to help Americans save for higher education.

IMAGE SOURCE: TaxCredits.net.

Here are four quick facts about the 529 college savings plan that you should know.

1. 529 plans are administered by individual states

There is no one single 529 account that everyone uses. Instead, 529 college savings plans are established on the state level, and almost every state sponsors one. While they all work similarly, each plan is different in everything from investment choices to the fees they charge. What's important to know is that you do not have to use your state's plan, nor the plan in the state where the account beneficiary will attend school. But because many states offer state income tax deductions to residents who use their home state's plan, you should start by researching your own state's plan.

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2. A 529 account resembles a Roth IRA

A 529 account is similar to a Roth IRA: Contributions are made with after-tax dollars, the money grows tax-free, and withdrawals are tax-free when used for qualified higher-education expenses. Money used for non-qualified items will be subject to income taxes and a 10% penalty on earnings only -- not on the original contributions. However, unlike a Roth IRA, a 529 plan does not restrict who can contribute based on their income.

3. You can change the beneficiary

Another great feature of the 529 account is that you can change the beneficiary of the account generally without incurring any tax consequences as long as the new beneficiary is within the same family. For example, you can use it for one child and then transfer the account to another child. Also, importantly, there are a few exceptions to the 10% penalty if the beneficiary does not need the money -- for example, if the student receives a scholarship. You will still owe income taxes on the account's earnings, however.

4. You can make a lump-sum contribution

College savings, like retirement savings, benefit greatly from the power of compounding. But unlike most tax-advantaged accounts with yearly contribution limits, the 529 account allows individuals to front-load their contributions up to five years. This is especially significant because while you have many decades to save for retirement, you typically have much less time to save for college.

Generally, every year, an individual can gift another person up to $14,000 per year -- the exclusion amount for 2017 -- without having to file a gift-tax return. The 529 account allows you to gift someone five years' worth of the annual exclusion amount for a total of $70,000 in one year. Therefore, two parents can contribute a whopping $140,000 at one time. And while that may not be doable for the majority of people, being able to make a large up-front contribution can make a big difference in how much savings you ultimately end up with.

For example, let's say two parents stay within the gifting guidelines and each contribute $14,000 into a 529 plan when their child is born, and then they make no further contributions. An account value of $28,000, growing at a conservative 5% for 18 years, would swell to about $67,000. Now let's assume they save that same $28,000 over the span of 18 years, contributing about $1,550 a year, earning the same 5%. The balance would then be about $46,000. That could mean their child needs to take out another $21,000 worth of student loans.

If you're interested in helping your child pay for college, a smart place to start is with a 529 account.

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