When to start saving for college: How to choose and understand 529 plans

Is the child born? You should be saving for college. Even if they aren't born yet, you could still be saving — but that's for over-achievers.

For the rest of us, a reasonable deadline is as soon as a child has a Social Security number: Then a savings plan should be set up.

But you have a lot going on.

You have housing costs and you're paying off that car. Maybe there was a wedding that took a chunk of your savings — and you feel like you'll be paying off your student loans until you die. The cash left over for your kid to pick up?

Not too impressive.

That's exactly why you should consider contributing to a tax-advantaged savings plan.

A 529 plan is an education savings plan offering income tax breaks, created to aid families that set aside money for future college costs while their children are still young.

Though contributions are not deductible on your federal tax return, earnings in 529 plans are exempt from federal taxes — and, in many cases, state taxes — so long as the withdrawals are used for qualified educational expenses. Many states also allow you to deduct 529 contributions from your income tax returns, provided the plan is sponsored by your state of residence (versus an educational institution).

The length of time between the day you begin contributing funds to a 529 and when your kid starts college is up to you.

Obviously, because of the time value of money, the sooner you begin contributing, the more time your money has to grow. So get started!

To help you out, here's a breakdown on 529 plans, what they are, how they'll help you and what to do if — gasp! — your kid decides not to go to college.

Wait — what is a 529 plan, exactly?

A 529 plan is like a Roth IRA, in that account holders invest after-tax money that grows tax-free and isn't taxed when used for qualified educational expenses. It is named after Section 529 of the Internal Revenue Code which created these types of savings plans.

There are two types of 529 plans: a college savings plan or a prepaid tuition plan. 

A college savings plan allows the account holder to set up an account for the student-to-be, aka the beneficiary. Typically, the account holder can choose among several investment options, including stock mutual funds, bond mutual funds, money-market funds or age-based portfolios, which adjust risk based on the age of the beneficiary. Generally, age-based portfolios become more conservative as the beneficiary gets older, according to the IRS.

With a college savings plan, you have the freedom to use the money at any college or university. But like any other investing account, investments in mutual funds for college are not guaranteed by state governments nor are they federally insured.

A prepaid tuition plan is a less-popular — and less-available — type of 529 plan. A prepaid tuition plan allows you to lock in the current cost of tuition at in-state colleges and universities in lieu of paying future prices. The money in a prepaid tuition plan can only be used for tuition and fees; expenses like room, board and books are not included. 

Who can open a 529 plan?

Practically anyone can open a 529 plan: you, a grandparent, an aunt or uncle, a family friend. Even the owner of that chess store who believes your daughter is a prodigy and wants to support her education? He can open a 529 plan in your child's name. Your kid can, too, once he or she is 18.

But the most likely contributor is you, the parent. 

What this could mean for you — a cash-strapped millennial parent — is this is a potentially important conversation to have with your own parents. 

Would they like to set up a tax-advantaged plan for their grandkid? How much would they be able to contribute?

Ask them to skip the birthday gifts and invest in your child's future in a far more meaningful way.

What should I look for in a 529 plan?

Saving for college in a 529 plan can involve hefty fees, which vary depending on the type of plan.

When shopping around for a 529 plan, watch out for administration fees, enrollment fees and broker fees. These may be collected by the state that sponsors the 529 or by the financial services firm that manages the plan. 

These costs can sometimes be avoided through specific fee waivers such as maintaining a certain account balance or setting up automatic account contributions. Again, such waivers are determined by individual plans. You might also get around having to pay these fees by opting for a direct sold plan — as opposed to an advisor-sold plan — because you can buy directly from the plan sponsor. 

You'll need to select your investment options carefully because those, too, will incur different costs depending on the investment type.

Lucky for you, lots of independent reviewers rank 529 plans against each other every year — for your Googling pleasure.

What if my child doesn't use the 529?

There are several reasons why your kid may not end up using the 529 plan for college expenses.

He or she may receive a scholarship, attend a military academy or simply decide college is not for them. 

In some cases, using funds from a 529 plan for non-college-related expenses will incur penalties. 

If your child earns a scholarship, penalties are waived. You will still need to pay tax on the earnings, effectively turning your tax-exempt 529 plan into a tax-deferred 529 plan.

If your child becomes incapacitated or is disabled, a new kind of 529 plan, called a 529 Able or 529 A, allows parents or other account holders to place money in a tax-free account for a special-needs child's medical and support expenses. This allows families to save for those lifelong costs without risking the child's eligibility for need-based government help like Supplemental Security Income or Medicaid.

If your child decides not to go to college, you have a couple of options. You can transfer the 529 to another potential student in the family — including the beneficiary's spouse, son, daughter, grandchild, niece, nephew and first cousin, among others. 

However, if you still want the funds to go to the original beneficiary for non-college-related use, you will be subject to income taxes and an additional 10% federal tax penalty on earnings.

Best-case scenario: Your kid finds a high-paying job even without a college degree, and reimburses you for the taxes and penalty.

One can dream!

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