When it comes to paying for your child's college education, do you feel prepared? Putting money aside in a regular savings account likely won't help you reach your goals the same way other savings vehicles can, like a 529 plan - an account specifically designed to encourage saving for educational costs.
Curious what a 529 plan is and how it works? A 529 plan is similar to a 401(k) plan, but whereas the latter type of account is used to build your nest egg, the former is used to pay for college expenses.
However, the tax advantages of a 529 plan are similar to a Roth investment retirement account since you pay federal income tax on your contributions, but then the earnings from your investments grow tax-free.
There are two types of 529 college savings plans: the prepaid plan and the savings plan.
529 college prepaid plan. With the 529 prepaid plan, you purchase tuition credits in your state's university system at current tuition rates. This means your child is protected against future hikes in tuition costs despite the likely increase in inflation. However, before opening a 529 prepaid plan, make sure your child plans to attend the school for which you are purchasing tuition credits to ensure the investment doesn't go to waste.
529 college savings plan. The 529 savings plan is a tax-advantaged account that allows you to accumulate assets that can be used toward any accredited college or vocational school in the United States. The funds can be used to pay for more than just tuition costs, including textbooks and other education-related fees.
Contribution limits. The annual maximum contribution allowed per person to either plan is $14,000, and if you are married, your spouse can contribute an additional $14,000 each year for a total of $28,000. Each spouse is also allowed to make a one-time contribution of $70,000 (five years worth of annual maximum contributions), but parents who opt for this will have to wait six years before they can start contributing again.
The total maximum contribution allowed on a 529 plan is $360,000 (market value) for each beneficiary. However, your assets can grow beyond that amount through investment gains.
Risk level and investment options. With a 529 savings plan, depending on the state, you can choose between several investment options based on factors such as your child's age, your asset allocation preference and investment risk level. You can also decide to invest your money in a portfolio of stocks, bonds and/or money market funds. However, don't assume your state's plan is the best option, as not all states offer tax deductions. If that's the case, you may want to open an account in another state with options that better suite your child's needs.
For a list of the best 529 plan options by state residency, see NerdWallet Investing's comparison of the top accounts.
Neda Jafarzadeh is a financial analyst at NerdWallet Investing, a financial literacy organization that helps investors select better mutual funds, figure out where to open IRA accounts and make smarter investment decisions overall.
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