College savings plans are different from prepaid tuition plans in some ways but offer the same tax breaks and objectives.
With a college savings plan, you contribute to a state-sponsored savings or investment plan whose funds are reserved for your child's or other beneficiary's future college expenses. In some cases, the trust fund that manages the money may guarantee a minimum investment return.
Your contributions grow tax-deferred until your child or other beneficiary begins to take money out to pay for tuition and other qualified higher education expenses.
Beginning in 2002, distributions from college savings plans (as well as prepaid tuition plans) for qualified higher education expenses became tax-free for plans that are sponsored by public institutions. For plans sponsored by private institutions, tax-free distributions began in 2004.
All 50 states have a website explaining their college savings plans. The College Savings Plan Network website provides a link to every state's college savings plan website.
In addition to tax-free distributions for qualified higher-education expenses, Section 529 plans offer the following advantages:
- Tax-deferred growth of contributions. While you pay for tuition with after-tax dollars, the earnings on your contributions grow tax-deferred until the beneficiary begins college. At that time, the child begins to take distributions as he or she uses up the pre-paid tuition. The tax law allows for tax-free distributions for qualified expenses.
- Control of the account. Section 529 plans keep you in charge of the financial decisions that affect use of the money. This includes retaining the right to change beneficiaries. In comparison, an UGMA or UTMA account becomes the property of the beneficiary when he or she reaches 18 or 21, depending on the state's definition of majority age.
- Front-loading. For 2021, you can give as much as $75,000 in a single year ($150,000 if married and filing jointly) to a Section 529 plan. That's five times the amount you can give in a year to a beneficiary as a gift and not have to pay gift taxes. By "front-loading" your investment, your account grows to a larger amount sooner. In general, a one-time contribution of $75,000 rules out additional tax-free gifts to the same beneficiary for another five years.
- Favorable weighting in calculating financial aid. Since Section 529 plans are considered your assets, the weight assigned to those savings is lower when calculating financial aid eligibility for the first year of your child's college education. In subsequent years, the amount the student received in the first year could affect financial aid eligibility.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next, we'll take a look at using UGMA and UTMA accounts as an alternative to paying for a child's or grandchild's college expenses.