Americans are getting serious about saving for college. A record total of over $205 billion has been invested in 529 higher education savings plans as of June 2013, according to the non-profit College Savings Plan Network. These tax-advantaged investment accounts are offered in every state, but sometimes without the 529 moniker. They can be named "Smart Choice," "Bright Start," or "College Advantage." Whatever they may be called, these state-established and maintained programs are an important tool for meeting the challenge of rising college tuition and expenses.
Tax favored status
"A 529 plan makes sense for any taxpayer who has funds that they want to dedicate to education costs at an accredited institution," says James Twining, a fee-only financial advisor based in Bellingham, Wash. "The tax free nature of the earnings -- and possible state tax deductions or credits -- if used for education, are just too good to pass up. The small costs levied by the various states are a minor drag on performance and are easily outweighed by the tax favored status."
Richard Frazier, a financial planner in Wilmington, N.C., agrees -- and adds that potential savers shouldn't be intimidated by the investment choices.
"Investments inside 529 plans can vary," Frasier says. "Most of them have what are called age-based investments. These investments automatically adjust themselves over time and get more and more conservative the closer the child gets to college. This is great for parents/owners of plans that are not investment savvy."
Two versions of 529 plans
Twining notes that there are two different types of 529 plans for investors to consider: college savings plans and pre-paid tuition plans.
"College savings plans are invested and their value is based upon the performance of the investments," he explains. "Pre-paid tuition plans become worth whatever the educations costs are at the time they are incurred."
While Twining generally favors the savings plan version, he says there is one exception where the pre-paid tuition plan could move to the head of the class.
"That exception would be for a student who is approaching college age, and will need the funds within a few years," he says. "The education goal is now a short term goal, and like all short term goals, the appropriate investment stance is conservative. In this low interest rate environment, it may well be advantageous to roll the college savings plan into a pre-paid tuition plan for those last few years before the expenses begin. By doing this, the value of the plan is 'locked in.'"
Consider a combination of solutions
Is a 529 plan the ultimate savings solution for higher education expenses? Michael Kothakota, an advisor in Raleigh, N.C., says he actually prefers a combination of investments.
"So, put some in a 529 plan, make use of a custodial account (UTMA/UGMA account) and then a Roth IRA," Kothakota says. "If needed, money can be taken out of the Roth IRA to pay for school tax-free. In the event your child receives a scholarship or chooses a school that is not expensive, they now have a jump-start on retirement. The money in the custodial account can be used to fly home if they are out of state, purchase a vehicle, or even be used to purchase a home."
What if college plans change?
But as every parent of a college-aged child knows, plans can change in an instant. So, what happens to the 529 plan if college becomes a "maybe in a couple years" thing?
"You can transfer the funds to a different family member and have them use the funds for a qualified education expense --including yourself," says Kothakota.
"This is especially nice for a family who has multiple children but does not want to open 529 plans for all of them," Richard Frazier adds.