What is a 529 College Savings Plan and How Does It Work [VIDEO]

The following is a video post from Jeff Rose, CFP at Good Financial Cents. The video gives a comprehensive overview of 529 College Savings Plan and how it works. Topics covered include: what is a 529 plan, who can contribute to the plan, who has control over the plan, different types of 529 plan, what happens if your child doesn’t go to college, and what happens if your child gets a scholarship.

VIDEO TRANSCRIPT
If you’re like me and already have children, you’re probably already freaking out about how much college tuition is going to be costing you in the next five, ten, or fifteen years. I know that I have been freaking out because I’ve seen how much college has been going up ever since I graduated ten short years ago. If you’re a parent in that same situation, let me introduce to you the 529 college savings plan.

I am going to share what exactly a 529 plan is, how it works and, and how you actually utilize it. I’ll also share the different types that are available to you, and then what are some of the benefits of using the 529 college savings plan in helping fund your kid’s college education. Ready to get started? Let’s go…..

First, what exactly is the 529 plan?

First and foremost, don’t get so wrapped up in the “5-2-9” numbers. Those just come from the IRS code when they came up with the name. The 529 college savings plan is a tax advantage savings and investment vehicle used purely, and I stress “purely” to save for your kid’s college. By putting money into the college 529 savings plan, your contributions or money that you put in is all after tax. Then, whenever you go to pull that money out all the interest and earnings that have accumulated from your contributions are completely tax free so as long as you use those towards your kid’s college education. Now that’s important. If you end up pulling that money out for something other than college tuition or college-related expenses, you will be taxed and penalized on the interest and/or earnings. But remember your contributions, the money that you put in, is all after tax, so you can actually pull that money out at anytime and not incur any tax or penalties. If that sounds familiar it is very much like the Roth IRA, except this is purely used for college.

Who can put money into a 529 plan?

Anybody. You can fund it. Your parents can fund it. A grandparent can fund it. Aunts or uncles can fund it, too. In fact, even friends and co-workers can fund it. Pretty neat, huh? A new site by the name of Clariity.com has a program setup where any members of your inner circle can fund it using their financial gift cards. As you can see, funding the 529 is super easy. That is one of the perks about it is anybody can fund it.

Parental Control Makes 529 Attractive

The other tool that you can use is what is called a custodial account. How that works is you put money into the account. There is typically a custodian, which is a parent or grandparent. Then the child doesn’t actually get the money until they turn 18 or the age of majority. Once that child turns 18 they can then take that money from the custodial account and do with it what they please. They can spend it on college if they want, but if they want to go out and blow it on you name it, they can do so.

What makes the 529 so attractive is that you’re always going to have an account owner and that owner can be a parent, it can be a grandparent, it can be whomever, but most importantly it is not the child. The child is then solely the beneficiary of the 529 plan. Once the child reaches the age of 18 within the 529 plan they are not in control of the money. That owner, which is typically the parent, is still in control.

With me, how I set up our 529, I am the owner and once my first son turns 18, if he doesn’t want to go to college and wants to pull that money out and do with it what he pleases, guess what; it is not an option. I am in control of the money. That is one very, very attractive feature, that you’ll always have your hands on that money to where your child can’t make any rash decisions and go out and blow that money, especially when you have been saving it for the last 18 years or so.

What if they don’t go to school?

That also brings up another question, “What happens if my child doesn’t go to college? Do I just lose that money or how does that work?” As a reminder, you can always pull out your contributions so the money you put in can always come out. The interest or earnings that have accumulated over that time though will be taxed and penalized if you don’t use it for college. One way to get around that is if you have, say, two children. You could actually transfer the money from the child that didn’t go to college over to the other child’s name where they can use it for their bachelor’s degree, master’s degree, doctor’s degree, whatever. You also have the ability to transfer it over into a close relative, so if you have a niece or nephew and want to transfer it over and your close to them you can also do that too.

What about scholarships?

Another common question I get is, “What happens if my child receives a scholarship, whether it is an academic or a sport scholarship?” How that works is this; let’s say they get a $10,000 academic scholarship and you’ve got $10,000 in your 529 college savings plan. Are you going to be taxed and penalized for pulling that money out? No. Whatever the scholarship amount is, you’re allowed to withdrawal that from the 529 college savings plan tax and penalty free, so that way you can save for your kid’s college and not have to worry if they do get that scholarship that you’ve been saving for nothing. That is one of the little benefits of the 529 college savings plan. Remember: you can pull out the contributions at any time.

What are the different types of the 529 college savings plans?

There are actually two different types. There is the prepaid tuition plan, and there is also the savings plan. The most popular option that I run into is the savings plan, but let me first quickly address the prepaid tuition option.

The Prepaid Tuition Plan

The prepaid tuition is exactly how it sounds. You are buying tuition based on today’s dollars to pay for college at a later time. How you determine how much you’re paying depends on the age of the child, the type of institution you think the child is going to go to whether it be a junior college, a state college or a private university. That is what makes the prepaid tuition a little bit difficult because, let’s say you want them to go to a private university, there is a different rate scale of how much you have to pay per month based on that. The few times I’ve come across that it is a pretty hefty penny to have to commit to to do the prepaid tuition. Double check with your state prepaid tuition plan to find out how much exactly you have to pay if you want to go that direction.

The 529 Savings Plan

The more common and more popular method is the 529 savings plan. How that works is there is no commitment so you can put in $250 today and never fund it ever again, or you can contribute so much per month. You can basically do it anyway that you want. Also if anybody else wants to add money into they can as well. Let me give you a quick example of how we use it in our own lives.

We opened up the college 529 plan for our first child. We started funding it and put a couple hundred dollars in the beginning. We were then putting in $50 a month on an automatic basis. Then every time we had a birthday or Christmas or some type of holiday where our kid would get money, instead of going out and buying more toys that he did not need, we would just put that into our college savings plan. That has just been a really easy and quick way to truly boost our college savings for him for going for school. We are doing the same thing with our second son, and we will do the exact same thing with our third son.

Those are just some of the common reasons why you might want to consider the 529 college savings plan for saving for your kid’s college. If you want more information, head over to my financial planning blog to see more. I have more information on the 529 plan and the other savings plan that are available to you.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

About the Author

By , on Mar 28, 2011
Jeff Rose
Jeff Rose is a Certified Financial Planner and co-founder of Alliance Investment Planning Group. He is also the author of Good Financial Cents, a financial planning and investment blog and he is currently working on his first book entitled Soldier of Finance. You can see more about his mission at the same titled blog Soldier of Finance.com.

Leave Your Comment (One Comment)

  1. Joanne says:

    I recently purchased the 529 prepaid plan for both my kids ages 6 and 7. The reason I chose the prepaid and not the saving is the risk. I am thinking what happens if there is a stock market crash just as they are going to college similar to the last one I would not have the funds to send them to college. At least with the prepaid there is something significant. I guess I am slightly risk averse.

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