The cost of college has more than doubled in the 21st century. Currently the average in-state student at a public university spends over $27,000 per year, while the average private university student spends over $58,000 per year.
Educational savings plans, known as 529 plans after a section of IRS code, are tax-deferred savings plans that can be used to pay for educational expenses. The District of Columbia and all states except Wyoming offer 529 plans.
While 529 plans are usually used to pay for college costs, recent legislation allows them to cover K-12 education and apprenticeship programs, student loan repayments, and Roth IRA contributions.
There are two types of 529 plans: college savings plans and prepaid tuition plans.
College Savings Plans
By far the most common type of 529 plan, college savings plans allow anyone – but typically a parent or grandparent – to establish a savings and investment account for a beneficiary – typically a child or grandchild.
The account holder contributes to the plan and chooses what to invest in. Investment options vary by state, but most states offer mutual funds including target-date funds and index funds. Some but not all states also offer socially responsible funds.
Anyone including friends and extended family can contribute to a 529 plan. You can open a 529 plan in any state, not just the state where you live, but tax benefits vary.
Maximum contribution limits also vary by state, from $235,000 in Mississippi and Georgia to over $500,000 in Pennsylvania, New York, and California.
College savings plans can be used to pay for any qualified expense, including tuition, fees, books, and room and board. Because funds are contributed post-tax, withdrawals are tax free.
Prepaid Tuition Plans
Prepaid Tuition Plans allow you to lock in college or university tuition at the current rate for a beneficiary who will not be attending for years. Only nine states participate -- Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Texas, Virginia, and Washington – and the money can only be used to pay tuition.
Prepaid tuition plans are a great hedge against the rising cost of tuition if you live in one of the nine states and your beneficiary knows they want to attend college in state. However, unlike college savings plans, the money cannot be used to pay for books, fees, room or board; nor can it be used for K-12 education or repay student loans.
If your beneficiary decides not to attend college in state, you can get your money back, but not the interest your investments have accumulated over time.
