529s & ESAs: Saving for College 101

A couple of years ago, I was reading an article about money and sending kids to college. “Blah blah blah,” it went (more or less), “and you should stick the money in a 529.”

“Oh, man,” I remember thinking. “A ‘529’? What the heck is that?” I got really concerned, and looked into it. I found some websites, created by out-of-breath journalists, telling me that college costs were rising, that I’d need to sell my kidneys on the black market to afford tuition for my kids, and that because I didn’t have a 529, I didn’t like my kids and clearly wanted them to have a terrible life.

I got so concerned, in fact, I opened TWO of these mysterious “five-two-nines,” despite the fact that — at the time — I didn’t actually even have any kids.

Clearly that was the right call, right? I mean, I liked my kidneys. And I liked my non-existent kids. And surely investing in their education was what I needed to do, right? Well … maybe not.

Today we’re going to look at this mysterious creature, the 529, and its cousin, the ESA. What are they? Does your family need one? Is one of them better than the other? How do you set one up? When should you set one up? And if you don’t have one, does that mean you secretly don’t like your kids?

What are 529s, anyway?

529s are a good thing. But — just to get this out of the way — if you don’t have one, you probably still like your kids.

A 529 is simply a fancy way of saying “a special savings account for college expenses.” Think of them as a retirement fund for your kid’s college: you invest money now in a mutual fund, and when it’s time to use the money to pay for college, the money will hopefully have increased, and you won’t have to pay any tax on that increase. And as a bonus, you can pay less in state taxes right now by putting money into a 529.

There’s actually a second kind of 529, but it’s less common. Basically, it lets you buy tuition credits down the road at today’s prices. The only downside — you have to pay them now. This kind of plan usually makes sense if your child is currently in high school, as it’s less risky than the other kind of 529. If your child goes to an out-of-state or private school, the state pays that school whatever the going rate for your in-state tuition is. If you want to look into these, just search Google for “prepaid tuition + [your state].”

You don’t have to invest in your state’s plan, and just because you put your money into one state’s plan doesn’t mean you have to send your kids to a school in that state. Plus, you aren’t limited to just public schools — 529s can be used for just about any college or university in the US (and several outside the country). You can search the list of schools here.

But when you think about where to invest, remember that there are often tax deductions you can take from your current tax bill when you keep the money in your own state. (You can see a state-by-state list of tax breaks here.)

And ESAs? What are they?

An ESA, or an Educational Savings Account, is like a 529; it’s simply a “retirement fund” for college savings.

There are benefits and drawbacks to using ESAs rather than 529s. For example, you can’t start an ESA once a child is 18 years old, and ESAs have to be used before the child is 30. For many people, that isn’t a problem. For others, it might be. There are some contribution limits for ESAs that might not work for some folks. And ESAs don’t give you tax benefits in the current year the way 529s do.

But there are some advantages to ESAs as well. You can withdraw funds from the ESA for private middle school or high school costs in addition to college (529s are limited to college and graduate school). Also, you can invest your ESA in a much wider variety of funds than you can with a 529.

The options given by 529s are probably broad enough for the vast majority of parents, but if you want extra control, an ESA might be a better match for you.

Should I go with ESAs or 529s? And which fund should I pick?

It’ll depend on how much you plan to invest, how long you have until your child enters college, what types of funds you’d like to invest in, which state you live in, and a few other factors.

Some financial experts encourage people to go with ESAs at first, and to then go with 529s if ESAs don’t fully meet their needs. One of the benefits to this strategy is that there’s more flexibility to the funds, stocks, or bonds you can pick. Keep in mind, though, that there are drawbacks to going with ESAs, and 529s might be better for you.

From the standpoint of wanting something simple, and wanting to get started with something, I’d look into my state’s options for 529s. If I liked the investment options it gave, I’d go with one of them. If not, I’d go with an ESA.

How do I open a 529 or ESA?

The actual process of opening an account is easy. It mostly involves filling out a form and sending in a check. You can also set up regular, automatic deposits from your bank account. (They like to make it easy for you to contribute.)

You can create an account for each of your children if you’d like to. But you might decide to do what I did when I created mine, and to list yourself as the beneficiary. (You might recall that when I set my accounts up, I didn’t have any children, so I had to name myself as the beneficiary.) As my daughters get closer to college, I’ll convert it over.

If you opt for this approach, be sure to investigate the rules for your state regarding 529 ownership transfers. Usually, they aren’t bad, but you want to make sure you don’t have unnecessary hoops to jump through.

But before you get to that, you should think about whether it even makes sense for you to put money into a “College Retirement Fund” at all.

Should I open a college savings account right now?

It depends.

Obviously, if your kids aren’t going to go to college, it’s not necessary. But you probably already figured that out. It depends on some other things, as well. Namely: is the rest of your financial house “in order”?

I really like Dave Ramsey’s advice on when to save for college. He says that your first priorities should be to have a cushion of savings in the bank, to pay off your debts, and to set aside money for your retirement (he recommends 15% of your income). According to Dave, you should be doing all three of those things before setting aside money for your kids’ college.

Here’s a quick rundown:

• Do you have at least $1,000 in the bank, available for “little” emergencies? If not, take care of that first. If so …

• Do you have any debts? If so, pay them off. If not …

• Do you have 3+ months of living expenses in the bank? If not, it’s a good idea to set money aside, in case you lose a job or have some other larger financial emergency. If so …

• Are you already setting aside 15% of your income for retirement? If not, focus on that. If so…

Congratulations! You can start thinking about saving for your kids’ college expenses.

So, as you can see, for a lot of us (myself included), there are a number of other things we need to do before we worry about saving for college. I’m not going to close my existing 529 accounts, but I don’t plan to put any more money towards them until I’ve got more money in the bank and am putting more of my income towards retirement.

If you have any questions about college savings plans, there’s a useful website at Saving For College that has a list of frequently-asked questions.