The best time to start saving for college — for your children, nieces, nephews, or other family and friends — is as soon as they're born. But if you didn't get off to a quick start, don't despair. You can start now by choosing among a number of different investment plans that not only provide the opportunity for your savings to compound tax deferred but offer the possibility of tax-free withdrawals for qualified expenses when the student enrolls.
In fact, some of these plans weren't introduced until 1995, and their tax-free withdrawal provisions weren't added until 2002. Other plans have been adapted over the years to increase contribution amounts, make them accessible to more people, or expand the way the money can be used.
Since every state offers at least one 529 plan, you have the flexibility to choose the one that best meets the criteria you set. In fact, you can open more than one 529 plan for the same beneficiary if you choose, since in most cases neither you nor the beneficiary have to live in the sponsoring state to participate in its plan.
Among the things you'll want to consider in choosing a 529 plan are:
- The investment options and their historical returns
- The fees, expenses, and state tax treatment of different plans
- Beneficiary rules
- Contribution limits
Remember, though, that as with any uninsured investment, returns on 529 savings accounts are not guaranteed and you could lose money, especially in the short term.
You may also consider a prepaid tuition plan, another type of 529 plan. With a prepaid plan, you pay for future college costs by buying tuition credits at today's rates. The catch is, some of these plans don't guarantee that your prepayment will cover the full cost when your child enrolls.
Most of the plans are sponsored by individual states, and the credits apply to public institutions in the state. There's also a Private College Plan, sponsored by more than 270 private colleges and universities. Credits you purchase through the Independent plan are guaranteed, and they can be used at any participating school.
ON THE RIGHT TRACK
With a fixed track, you choose whether to invest in equities, fixed income, balanced, or stable value funds. The portfolio's exposure to risk doesn't change over time, and the results are based on how the underlying investments perform.
COVERDELL EDUCATION SAVINGS ACCOUNTS
With an ESA, you choose the investments for your account, which gives you more control over how your money is allocated than you have with most 529 plans. There are limitations, though. Instead of investment ceilings that can be $300,000 or higher as they are for some 529 plans, annual ESA contributions per beneficiary are capped at $2,000. There are income limits governing who can contribute to an ESA. And the beneficiary must be younger than 18 when the account is opened, and must use the money before turning 30, although you can change beneficiaries to another member of the same family.
US SAVINGS BONDS
There's a small catch to the tax break for education expenses on US savings bonds: Your adjusted gross income must be less than the limit set by Congress in the year you withdraw to qualify for the tax-free benefit. Of course, there's no way to predict what that amount will be when you are ready to use the money. But you're free to hold on to the bonds if you don't qualify or cash them in and pay the tax that's due. In that case, you can spend the money for nonqualifying expenses if you wish, without penalty.
EVALUATE YOUR ALTERNATIVES
- Compare the investment alternatives of different college investment plans, and narrow the list to those that are best for you. You may decide to use a combination of plans.
- Evaluate 529 college savings plans to find the ones with the most attractive investment alternatives at the lowest cost. You may want to start by investigating your home state's plan.
- Combine making contributions to a 529 plan with putting money into some other college saving opportunities such as an ESA or savings bonds, to diversify your investments.
- Don't plan on raiding your retirement plan to pay for college expenses — your beneficiary could receive grants or scholarships, but you alone are responsible for your retirement.