The year is 2040. A four-year education now costs $500,000.
On average, college tuition rates increase by 8% every year. To put that in perspective, for a baby born today, college tuition will be about three times the current rate when that child begins college at 18 years old.
Meanwhile, household income has increased by 1.8% to 3.3% annually in recent years. Between 2017 and 2018, the increase was even smaller at 0.8%.[1]
The question that comes to mind is how am I ever going to pay for my child’s education?
Picture: The Nott Memorial at Union College, Schenectady, New York
Solutions for saving for future education expenses exist and they may help on your tax return, too.
Qualified Tuition Plans or Section 529 plans, as they are more commonly known, fall under Section 529 of the Internal Revenue Code. Hence the name 529 plan.
The plans themselves are administered by the states and the District of Columbia.
What are 529 and what can they pay for?
The 529 plan was originally created to provide a tax-advantaged investment vehicle to encourage people to save money for post-secondary education costs – college or university and graduate school.
In recent years, the rules have expanded. 529 plans can now be used to pay for a student’s K-12 education[2] and for apprenticeship programs.
The funds from a 529 plan can be used to pay for qualified expenses – tuition, fees, room and board, and related costs like books.
Be careful, withdrawals for other reasons are subject to a 10% penalty.
Are there different types of 529 plans?
Two types of Section 529 plans exist – College Savings Plans and Prepaid Tuition Plans. The plans differ significantly.
College Savings Plan
Under the savings plan, the account holder, typically the parent or grandparent of the student, contributes money to the plan on behalf of the beneficiary. The account holder selects the types of investments. Many 529 plans offer target-date funds, which adjust the investment holdings over time, and become more conservative as the beneficiary approaches college age.
Prepaid Tuition Plan
Prepaid tuition plans are less common than savings plans because they are only offered by a few states and a select number of higher education institutions.
The plan enables the account holder to ‘lock-in’ at tuition rates now. The state that oversees the plan pledges that the funds will increase to mirror the inflation in college tuition and that the funds will be able to cover the tuition cost when the child is of college-age. Typically, the funds cannot be used to pay for room and board.
What are the tax advantages?
State Income Tax Deduction
529 plans are administered at the state level so tax advantages come into play on your state return, not on your federal income tax return.
While residents typically invest in their own state’s 529 plan, individuals can contribute to plans in different states. For instance, if your state does not offer a state income tax deduction or credit, you can compare plans outside of your home state for the best option.
I highlight two states, Vermont and New York, to show examples of different tax credits and deductions.[3]
Vermont’s 529 savings plan is the Vermont Higher Education Investment Plan (VHEIP). Vermont offers a 10% credit on the first $2,500 contributed to the VHEIP plan for each beneficiary. For a couple married filing jointly the credit is 10% on the first $5,000 contributed for each beneficiary. These tax benefits are available to contributors regardless of their income.
New York offers New York’s 529 College Savings Program. Single taxpayers filing in New York can deduct up to $5,000 annually in contributions made to the Direct Plan on their state income tax return. Taxpayers who are married filing jointly can deduct up to $10,000 made in contributions annually.
Tax-Deferred Earnings
Contributions grow on a tax-deferred basis. Withdrawals are tax-free as long as the funds are used to pay qualifying expenses – tuition, room and board, fees, etc.
The Bottom Line
Starting early and regularly contributing to a 529 savings plan can make a huge difference when your child begins college.
Compounding interest will be on your side if you start a plan early on in a child’s life. You can play around with this calculator from Vanguard to see how your savings could match up to what you will need to have saved to cover tuition.
To ensure that you reap the tax advantages of contributing to a 529 plan make sure you keep good records and make a plan with your tax professional.