There are, however, a number of options for parents and other relatives to set aside money to help with students' expected college costs. And for many families, the best of them is the Section 529 plan.
What is Section 529?
Section 529 is a provision in the tax code that allows families to contribute significant amounts of money to state-sponsored programs on a tax-advantaged basis to pay for college costs. Nearly all states have at least one active Section 529 plan, and anyone in the country can choose to participate in any state's Section 529 plan. You don't have to be a state resident, though in some cases there may be state tax benefits to participating in your own state's plan.
There are two kinds of Section 529 plans: Investment plans, in which families contribute money to one or more mutual funds, to be withdrawn when the beneficiary attends college, and pre-paid tuition plans at state universities.
Advantages of Section 529 College Savings Plans
While you cannot take a current year tax deduction for contributions to Section 529 plans, these programs have some significant advantages for parents and other family members who contribute:
- You can contribute large sums of money.
- Lifetime total contribution limits are very high - up to $235,000 to $500,000, depending on the plan.
- Money in a Section 529 plan grows free from income tax, taxes on dividends and capital gains tax as long as it's in the account.
- Withdrawals are not subject to federal taxes as long as they are used to pay for qualified college costs.
- There are state tax breaks for 529 plans in 30 states.
- Beneficiaries don't control the account. This means you can ensure that your beneficiary spends it responsibly.
- Very low minimum investments required to get started.
- You can change beneficiaries. So if one child dies, or elects not to go to college, you won't be penalized - just find a new beneficiary.
- No income limits: Anyone can qualify for the Section 529, regardless if income or employment status.
- Assets in 529 plans are not counted in your taxable estate.
Effects on Financial Aid
If the parent or student owns the account, then assets in a 401(k) are counted as parental assets under the federal methodology for calculating need-based financial aid. However, assets held in a Section 529 plan owned by grandparents, aunts, uncles or anyone else are not counted as available for college expenses using federal methodology, and not listed on the FAFSA form. This helps preserve financial aid available and reduces the expected student and parental contribution under federal rules.
While Section 529 does not allow you to make qualified withdrawals for secondary or elementary school expenses (the Coverdell Education Savings Account may help with these expenses), it is a flexible and powerful tool for many families, with a variety of applications.