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College Savers Risk Missing Out on This Valuable Tool

Maurie Backman, The Motley Fool

With the cost of attending college going nowhere but up, many U.S. families are struggling to pay for their kids' higher education. As such, students are often forced to resort to loans, and then carry loads of debt with them for years following graduation.

A big part of the problem stems from Americans' inability to prioritize college savings. According to financial services firm Edward Jones, 36% of parents with children under the age of 18 do not set aside any money for future education expenses.

Glass jar with coins labeled "College"

Image source: Getty Images.

But it's not just that parents aren't saving; it's that they're not saving efficiently. An estimated 67% of Americans don't know what a 529 plan is, reports Edward Jones. This lack of knowledge is leading parents to favor other college savings strategies, such as socking money away in the bank, pursuing federal financial aid, or falling back on private student loans. And in doing so, they're missing out on a world of tax savings.

The tax benefits of using a 529

Many people shy away from 529 plans because they've never heard of them, don't understand how they work, or find them too restrictive. But the reality is that 529s are an effective college savings tool that more people would be wise to capitalize on.

A 529 is a tax-advantaged savings plan offered by almost every state for education purposes. Back in the day, these plans were reserved for higher education only, but recent changes to the tax code expanded their use to cover K-12 tuition expenses, too.

When you contribute money to a 529 plan, you don't get an immediate tax break on that sum. However, once that money is in your account, you get to invest it for additional growth. The gains you enjoy on that money are then yours to keep tax-free as long as you use your 529 funds for educational purposes. This means that if you contribute a total of $30,000 to your 529 over time, but your investments allow that sum to double, you won't pay taxes on your $30,000 in gains if you use that money for qualified education expenses. Furthermore, while there's no tax break at the federal level for funding a 529, some states offer tax incentives for contributing to one.

Are 529s too restrictive?

Some people who know about 529s stay away from them because they feel they're too limiting. It's a valid concern. When you save in a bank account or traditional brokerage account, that money is yours to use for whatever purpose you please. If you fund a 529 and wind up using the money for noneducational purposes, you'll face a 10% penalty on the sum you remove from your plan. But that penalty will only apply to the gains portion of your account -- not your principal contributions.

Additionally, 529s are fairly flexible in that they allow you to swap beneficiaries as needed. This means that if you fund a 529 for your oldest child's education, but that child doesn't end up going to college, you can designate a sibling as a beneficiary. And if that doesn't work, you can hang onto those funds and reserve them for grandchildren or other family members.

Just as important, there are no income limits associated with 529 plans; you can fund one regardless of how much you earn. Similarly, there are no age restrictions or limits for accessing funds from a 529. It doesn't matter if your child decides to go to college at age 40 -- that money is still on the table.

Of course, 529 plans aren't perfect. Some charge high fees and offer limited investment choices. The good news, however, is that you're not limited to your home state's plan, which means you can pick the one that best works for you.

Let's face it: College is becoming a more expensive prospect by the day. If you're going to save for it, it pays to consider putting some money into a 529. And if you're not planning to save for college at all, you may want to rethink that plan. Otherwise, your child might graduate with a pile of debt that takes years to get rid of.

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