As a doctor, you likely graduated medical school with thousands of dollars in student loan debt.

Fortunately, there are ways to prevent this from becoming a generational pattern. You can potentially minimize that debt for your children by enrolling in a state 529 college savings plan.

Let's take a closer look at what every parent should know about them.

What is a state 529 college savings plan?

A 529 plan is a tax-advantaged savings plan designed to save for future education costs. These plans are sponsored by states, state agencies and educational institutions.  They are authorized by Section 529 of the Internal Revenue Code, and there are no limits on:

  • Age.
  • Income.
  • Annual contribution.

There are, however, lifetime contributions limits, which vary by plan. Most plans allow you to link them to you bank account or to contribute through automatic payroll deductions.

What are the tax implications of 529 plans?

Earnings in 529 plans accumulate on a tax-deferred basis. Unlike other investments, you do not pay capital gains taxes on the growth in the account each year.

Distributions do not apply to federal income taxes when used for qualified higher education expenses. As long as you use the money for qualified education purposes, you won’t pay income tax on any withdrawals. This includes paying for tuition at:

  • More than 6,000 U.S. colleges and universities.
  • More than 400 foreign colleges and universities.

It also applies to:

  • Fees.
  • Books.
  • Supplies.
  • Equipment.
  • Room and board.

The definition of qualified higher education expenses has recently expanded. Since 2015, you can use 529 funds to buy computers for education purposes. Since 2017, up to $10,000 annually can be used for K-12 tuition.

One thing to keep in mind is that you do not get a federal tax break for the contributions made to a plan. However, some states offer income tax incentives for contributions to the state’s 529 plan. These include state income tax deductions and tax credits.

What are the types of 529 plans?

There are two main types of 529 plans:

  • College savings plans.
  • Prepaid tuition plans.

College savings plans work much like a Roth 401(k) or Roth IRA. You invest after-tax contributions in mutual funds or similar investments. You also determine the investment allocations of the account assets based on what the plan provides. In general, a college savings plan enables you to change your investment options twice per calendar year. The plan account can increase or decrease in value based on the performance of the investment options chosen.

Meanwhile, prepaid tuition plans enable you to pre-pay the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. (There is also the Private College 529 Plan, which is a separate prepaid plan for private colleges.)

What happens if my child gets a scholarship or doesn’t go to college?

Although rare, there is a chance your child does not need some or all of the money invested in your 529 plan. If that happens, here are a few things to keep in mind.

  • Your child can still use the money for room and board (as long as they are enrolled at least half-time).
  • If you have more than one child, another one of your children can use the money.
  • You could leave the money in the plan in case the child wants to use it for graduate school. *Parents can also make themselves the beneficiary and use the money to fund their own education.

Does investing in a 529 plan impact financial aid eligibility?

The value of a 529 plan owned by a student or their parents is considered an asset. You must list it as such when you fill out the Free Application for Federal Student Aid (FAFSA). The impact on financial aid amounts primarily depends on the type of plan and the value of the account. However, you do not need to report account withdrawals on the FAFSA. (Remember, saving money in a 529 plan minimizes the need for financial aid in the first place.)

What if we use the money for non-educational purposes?

You do not have to forfeit your 529 funds if you opt to use it elsewhere. But you will pay income tax and a penalty on the earnings portion of any non-qualified withdrawal. This penalty will be waived if:

  • The beneficiary receives a tax-free scholarship
  • The beneficiary attends a U.S. military academy
  • The beneficiary dies or becomes disabled

Are there fees and expenses in a 529 plan?

There are fees and expenses associated with 529 plans. Fees vary based on:

  • Whether you opt for a education savings plan or a prepaid tuition plan.
  • How the plan is sold.
  • The underlying investments.

You should evaluate the fee structure of plans before determining which one to invest in. According to Morningstar, the industry has cut fees in the recent past to make the plans more attractive.

What are the top 529 plans?

You are not limited to the 529 plan offered in your state. You also do not have to use a plan based on the college your child will attend. You can live in one state, buy a plan in another state, and attend college in another state. You can typically roll over your funds from one plan to another 529 plan once per 12-month period.

Each year, Morningstar assigns Analyst Ratings to college savings plans. In 2018, Morningstar assigned analyst ratings to 62 plans, which represent more than 95 percent of assets invested in 529 plans. The qualitative Morningstar Analyst Rating scale has five levels:

  • Gold.
  • Silver.
  • Bronze.
  • Neutral.
  • Negative.

Key takeaways

The cost of higher education has never been, well, higher. Fortunately, there are ways parents can help children combat student loan debt head-on. In order to do so, it's important to understand:

  • The different types of state 529 college savings plans.
  • The tax implications of state 529 college savings plans.
  • All the different ways you can use these funds.

It's never too early to start saving for college. In 2018 and beyond, a state 529 college savings plan will continue to be a viable option for many.

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