Parents are not limited to standard taxable investment accounts when saving for college expenses. There are several investment plans that offer significant tax advantages. These include:
529 plans are among the most popular approaches to building college savings. Most states and the District of Columbia offer some type of 529 plan, and most major financial institutions (including T. Rowe Price) have established relationships that allow them to manage 529 plans.
Savings plans let you set aside money (typically $320,000 or more) in a professionally managed account that can be used at nearly every U.S. college and university.
Prepaid tuition plans let you pay for future education at discounted rates set today. These plans are appealing in that they offer cost certainty, especially if you are targeting a specific school. Plan assets typically also can be used to pay for other schools, though they may not cover all expenses.
- Any withdrawals used to pay qualified higher education expenses are free of federal income tax and may be state tax-free as well.
- There are no income restrictions.
- The account holder (usually a parent) retains control of the assets.
- Some states offer additional tax benefits-for example, there may be a state income tax deduction for your contribution.
- 529 plans can largely be used in conjunction with other federal education incentives, such as Education Savings Accounts and the Hope Scholarship and Lifetime Learning Credits.
Earnings on withdrawals not used for qualified educational costs may be subject to federal and state income taxes and a 10% federal tax penalty. In addition, an account holder may have limited investment options, depending on the particulars of the plan you select.
529 plans vary from state to state, and each has somewhat different costs, investment options, and tax incentives. A good game plan is to compare national plans with those that your state offers.
Please note the plan's disclosure document includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.
There are a number of other plans and tax-savings strategies parents can use to enhance their college savings efforts. These include:
- Select investments that limit taxes on investment earnings. For example, some mutual funds focus on minimizing taxable distributions.
- Interest on redeemed U.S. government Series EE and Series I savings bonds is exempt from federal taxation when the proceeds are used for college tuition or for contributions to 529 plans or Education Savings Accounts and certain conditions are met.
- IRA withdrawals can be used to pay for qualifying family educational expenses without incurring the 10% penalty for premature withdrawals before age 59½ (although income taxes in most cases will still be assessed, and you will lose the benefit of using those assets for retirement).