Money Talks, So Should You

Explaining 529s and pre-paid tuition plans

Tom Anderson
by Tom Anderson, Dimespring Contributor  (@bytomanderson)

Kids grow up fast and so should your college savings. It doesn't matter if your child is still in diapers – saving for college should be a priority if you want to avoid sticker shock.

For the 2011-'12 academic year, in-state tuition and fees at public universities averaged $8,244, 8.3 percent higher than the academic year before, according to the College Board. Normally, college costs grow at about double the overall economy's inflation rate. States that face tight budgets, most notably California, sharply increased tuition and fees at public universities, which contributed to the steep rise this year.

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Parking money in a low-yield savings account is not going to keep up with the rapidly rising costs of getting a higher education. While there are many ways to build a college kitty, a 529 savings plan is the best choice. Here are the basics to know:

What exactly is a 529 plan?

Assets held in a 529 plan protect your earnings from federal income taxes if used for qualified college expenses (tuition, fees, books and room and board). Another big plus: 529 money barely affects your child's changes of receiving financial aid.

States also offer prepaid tuition plans, which are confusingly called 529 plans too. These plans lock in tomorrow's tuition at today's prices. As tuition rises and states lack the money to cover the promises they have made to investors, many states are closing these plans because they are underfunded. You’re better off with a 529 savings plan, because you’re not dependent on state IOUs. You also have more flexibility about how to spend your college fund.

Where do I find a 529 plan?

In 48 states and the District of Columbia. (Tennessee closed its plan and endorses the Georgia plan and Washington only offers a prepaid tuition plan.)

Most states offer two types of college-savings plans: plans sold directly by the state and plans sold by brokers and financial advisers. Plans sold by the states directly have lower fees and less investment choices than those sold by brokers and advisers, which charge commissions.

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Investors continue to pour money into 529 plans. In 2012, the Financial Research Corporation reports that assets in 529 college savings plans grew to $158.3 billion, an 8.1 percent gain from the same time a year earlier.

Which plan should I pick?

Your own state's plan, in most cases. The tax break you’ll receive by buying your state's direct-sold 529 plan usually offsets advantages of investing in another state's plan. Two-thirds of states give residents a state income tax deduction or credit. Go to the College Savings Plan Network to find out the tax benefits of your state's 529 plan.

If your state doesn't offer a tax break, or if you live in five states (Arizona, Kansas, Maine, Missouri or Pennsylvania), residents receive tax breaks no matter what 529 plan they choose. In that case, pick the direct-sold 529 plan that best fits your needs. Check out Savingforcollege.com’s ratings, which ranks state plans.

How should I invest my 529 plan money?

There are basically two choices with 529s:

Most plans offer about a dozen investing choices, including actively managed funds and index funds as well as a money-market fund or savings account. (Jason, we will add links to forthcoming stories on actively managed funds and index funds.)

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A lot of plans also have “age-based” portfolios, which shift the mix of stocks, bonds and cash in your account to make it more conservative as your child grows closer to college age. The automatic nature of an age-based portfolio is a good way to stay on track without having to fiddle your plan investments every year.

You can only change your investment mix once every 12 months. Also keep in mind that these plans don't provide a lot of flashy investment options. But remember, that’s not what they’re intended for. 529 plans take the hassle out of saving for college, so you can spend more time with your kids and less time worrying about your finances.

 

Tom Anderson is a freelance writer in Brooklyn, N.Y. His work has appeared in Forbes, Kiplinger’s Personal Finance and Monocle.