T. Rowe Price Group, Inc. (TROW), AllianceBernstein Holding LP (AB): Why 529 Plans Are the Answer for College Savings

With college costs soaring, students face a seemingly insurmountable challenge: how to come up with the money to attend college without digging themselves into a huge hole of debt that will dominate their financial lives for years after they graduate.

But parents and grandparents are answering the call, according to the College Savings Plans Network. By using tax-favored savings vehicles known as 529 plans, family members are taking advantage of the chance to set money aside for their children’s or grandchildren’s education while reaping some rewards from the IRS in the bargain.

Why 529s are on the rise
The College Savings Plan Network’s recent report said that use of 529 college savings and prepaid tuition plans hit a new record in 2012, with the average account balance rising 12% to $17,174. The number of accounts rose more modestly, with 11.1 million accounts as of the end of 2012 versus 10.7 million in the previous year.

The healthy returns in the stock and bond markets also played a big role in boosting overall college savings. The total amount invested in 529 plans also hit a record, topping the $190 billion mark, up more than $25 billion from 2011.

Why should you use a 529?
529 plan accounts for college savings work a lot like IRAs and 401(k) plan accounts for retirement savings. In a 529, you don’t have to worry about paying taxes on the income and gains that your investments generate. As long as the money stays within the plan, it’s tax-deferred. Moreover, if you eventually use the money in the 529 plan for qualified educational expenses, any income on your investments becomes tax-free, amounting to a big subsidy from the IRS toward a college education.

The tax savings in a 529 plan can add up to a lot. If you save $10,000 and invest it in a normal taxable account generating returns of 5%, then you’ll earn $500 in income every year. Someone in the 25% tax bracket will have to pay $125 in taxes annually on that income, adding up to $2,000 or more over the course of 16 years or so of saving for college. In a 529, that’s extra money that you can use toward college expenses.

How to do better
The problem, though, is that just over $17,000 toward college expenses doesn’t go very far. The average room and board for a single year at a public college or university is slightly above that figure, and for private schools, $17,000 won’t even pay for half a year of expenses.

Obviously, the best answer is to save more in your 529 plan. But if you’ve already saved as much as you can afford, consider these tips to boost the investing power of what you have: