To encourage families to start saving early for college, all states now sponsor what are commonly called 529 plans. Named after the section of the federal tax code that allows them, they offer significant tax benefits.
There are two basic types of 529 plans: savings plans and prepaid tuition plans. The more popular is the savings plan.
With a 529 savings plan, parents open an account and choose an investment strategy. Earnings accumulate tax free and withdrawals can be made tax free, when it's time to pay for a child's college expenses including tuition, books, and room and board.
How it works
Money from a state-sponsored college savings plan can be used to pay for educational expenses at any accredited college or university.
Each savings program offers parents several different investment choices. Because many state programs are open to nonresidents, it makes sense for parents to shop around for a plan that best meets their financial and educational needs.
A popular type of college savings plan begins with some aggressive investments and grows more conservative as the potential college student grows up.
Many plans allow anyone -- from any state -- to contribute to a 529 plan. If you start a 529 account for your child in your home state, grandparents or even friends can contribute to it, even if they live across the country.
For example, if you start a 529 plan in Minnesota, relatives or friends who live in Oregon can still contribute. The caveat is that some states may charge residents a tax on earnings on out-of-state 529s.
A parent has three basic choices:
- Hang on to the savings plan.
- Transfer it to another family member.
- Cash out and pay a penalty.
So you've planned ahead for your child's education. What happens if a potential college student decides not to go to college?
Some parents hang on to the 529 plan in case the child decides to attend university at a later date. Others transfer the account over to another family member.
Some parents decide to cash out the plan and pay a penalty. Most states collect a penalty of 10 percent of the earnings on any withdrawal that is used for non-educational purposes.
A federal penalty equal to 10 percent of earnings will be charged as well. No penalty will be assessed if a beneficiary should die or become disabled.
While the tax-free withdrawals clearly make 529 plans attractive financial options, they may not be right for every family. The reason? Participating in a 529 plan affects a family's eligibility for financial aid.