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How Do 529 College Savings Plans Work and Are They Worth It?

Prostock-Studio / Getty Images/iStockphoto
Prostock-Studio / Getty Images/iStockphoto

The college admissions and financing process is nothing short of daunting for many Americans. With costs of higher education skyrocketing, particularly for private institutions, it’s never been more important to start saving for college as early as possible.

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The 529 college savings plan is one of many financing options you may have heard about or investigated on your own. If you’re looking for more information about what a 529 plan is, how it works and whether it’s worth it, read on.

What Is a 529 Plan?

A 529 plan is a college savings plan that provides tax advantages when used for qualifying purposes. A 529 plan is something like a Roth IRA or 401(k) plan for educational savings. Contributions are not federally tax-deductible, but earnings grow tax-free, and distributions for qualifying educational expenses are also tax-free. Many states also provide a tax deduction or tax credit for residents using an in-state 529 plan.

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How Does a 529 Plan Work?

A 529 plan has an owner and a beneficiary, but they can be the same person. The owner chooses the beneficiary, selects the investments and determines when withdrawals will be made. The owner can also change the beneficiary at any time, without the beneficiary’s approval. This can open up various strategic options for a 529 plan that you might want to discuss further with your tax or financial advisor.

Benefits of a 529 Plan

The main attraction of a 529 plan is its tax advantages. You may be able to get a state tax deduction for your contributions, and your earnings grow tax-free. When distributions are used for qualifying educational purposes, those withdrawals are also tax-free. Another main advantage of 529 plans is that they are considered parental assets. This means that only a maximum of 5.64% of 529 plan assets can be used when computing financial aid for children.

Is a 529 Plan Worth It?

The advantages of a 529 plan make it a smart way to save for college in certain circumstances. For example, if you’re sure you’ve got a child who’s destined for higher education and you can afford to make contributions, the 529 plan is an excellent way to go. However, if you have to sacrifice your retirement savings to make 529 contributions, or if you’re uncertain on whether or not you’ll be able to take the money out for college expenses, it might not be the slam dunk that it appears to be. 

What Other Options Might Be Better?

Custodial accounts, also known as UGMA/UTMA accounts, generally offer more investment flexibility and can be used for any purpose at all, not just qualifying educational expenses. While not having the tax benefits of a 529 plan, their flexibility might appeal to families who are unsure whether or not they’ll be able to spend the money on qualifying educational expenses.

A Roth IRA is another way to set aside savings that can be used for any purpose and can be invested in a wide range of assets. Although Roth IRA earnings can’t be withdrawn without penalty before age 59 1/2, contributions can be withdrawn tax- and penalty-free at any time, for any purpose. In that sense, a Roth IRA can act as a type of hybrid account; contributions can be withdrawn for educational expenses if needed, but if not, assets can remain in the account and grow until retirement. 

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This article originally appeared on GOBankingRates.com: How Do 529 College Savings Plans Work and Are They Worth It?