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529 College Savings Plans

One of the biggest challenges when planning for your child’s higher education is the cost. To cover college expenses, many people choose a 529 college savings plan. So what are 529 college savings plans and are they right for you?

A 529 college savings plan is a savings plan with tax advantages used to save up for education expenses in the future. Also known as a qualified tuition plan (QTP), a 529 college savings plan is authorized by Section 529 of the Internal Revenue Code and is set up by each state. The plan covers post-secondary education, K-12 tuition, and apprenticeship programs.

Here, I will talk about 529 college savings plans, explain what they are, and who benefits from using them (hint: high earners). I will also answer some common questions about the types of plans, the pros and cons and ultimately whether they are worth it.

What are 529 college savings plans?

529 college savings plans are tax-advantaged plans which involve the parents or grandparents of a child opening an account for education savings. The money the account owner invests in the account has two main tax benefits: (1) you don’t pay state income tax (depending on the rules in your state) and (2) the earnings in the 529 plan are not subject to federal and state income tax (depending on the rules in your state), so long as you spend it on a qualified tuition program or other educational expenses.

The states run the 529 college savings plans, meaning you have over 50 of them to choose from. The account holder doesn’t need to set up a college savings plan in the beneficiary’s home state, although you aren’t likely to get state tax benefits unless you use the plan created by your state. You can also change beneficiaries throughout the life of the 529 plan, so you’re not locking yourself into using a specific 529 account for a specific person.

There are no annual contribution limits on how much you can contribute to a 529 plan but there are a few limits to keep in mind. First, each state has its own rules on the total amount of the contribution that you can exclude from your income each year. Second, contributions to a 529 plan count as gifts for purposes of the gift-tax which means that you are subject to a $15,000 per beneficiary contribution in 2021 (or up to $30,000 from a married couple). A gift over that amount will use up part of the gift-giver’s lifetime gift tax exemption or possibly subject them to paying gift taxes.

As for limits on withdrawals, you can withdraw an unlimited amount to pay for eligible post-secondary educational institutions and up to $10,000 each year for K-12 students.

Types of 529 college savings plans

There are two types of 529 college savings plans. These are College Savings Plans and Prepaid Tuition Plans.

College savings plans

A college savings plan is the most commonly used type of plan. With this type of plan, the account owner opens an investment account for the beneficiary. You use the investment account to save for the qualified higher education expenses of the beneficiary. The expenses covered include tuition, mandatory fees, and room and board.

With a college savings plan, you have investment options such as mutual funds and exchange-traded funds. Plans typically have two types of investment portfolio options: static funds or age-based. With an age-based portfolio, the investments become more conservative as the college-age grows near. Static funds allow you to control the asset allocation.

Though the FDIC may guarantee investments in some bank products, college saving plan investments in mutual funds and exchange-traded funds are not often guaranteed by the state. With this type of plan, there is a risk as there may be no investment returns, negative returns, etc. You are essentially investing in the stock and bond market.

Prepaid tuition plans

A few states and educational institutes offer prepaid tuition plans. For prepaid plans, the account holder purchases credits at certain universities and education institutes. They prepay some college expenses at current prices, thus “locking in” tuition at current rates. You can use this plan for beneficiaries who are not planning to go to college in the coming years.

These plans are not available for K-12 education, and the savings do not cover room and board costs. Some prepaid plans may only be available for certain institutes. Unlike college saving plans, prepaid tuition plans have residency requirements. They are not guaranteed by the state. The value of a prepaid tuition plan increases with time, and the money withdrawn is tax-free.

Personally, I’ve never understood the value of a prepaid tuition plan and would avoid it unless you’re 100% certain that your son or daughter is going to be attending a specific university (and even then I wouldn’t do it).

Who are 529 college savings plans for?

529 college savings plans are for people with children or other family members planning on pursuing higher education, K-12 education, or apprenticeship programs, who are already contributing the maximum amount to their retirement accounts.

They are beneficial for people who are saving for college and hope to eliminate financial problems when the time for enrollment comes. A 529 college savings plan can also help a beneficiary with their student loan repayments since you are now allowed to use up to $10,000 (lifetime limit) from a 529 plan to repay student loans.

It’s a little known fact but you can also start a 529 plan before you have kids (the initial beneficiary will be you and you’ll switch it to your children down the road).

Are 529 plans worth it?

A 529 plan is worth it in that it has several tax benefits for the account owner and helps the beneficiary save up for college. However, it has its disadvantages, including less financial aid and limited investment options.

What are the benefits of a 529 savings plan?

There are many benefits of a 529 savings plan, including income tax benefits, flexibility, and the range of choices available. Here are some benefits of a 529 savings plan:

No federal income tax

For educational costs, student loan repayment up to $10,000, and apprenticeship programs, the withdrawals are free from federal income tax. Remember that you already paid federal income tax on the contributions, so it’s the earnings that we’re discussing. A properly invested 529 plan should grow considerably over the account’s lifetime and being able to withdraw the earnings without paying federal income tax is a huge benefit of the plans.

State tax breaks

In some circumstances, your state may offer a tax deduction, tax credits, or related tax benefits to the taxpayer. These state income tax benefits on contributions and often have some limitations depending on the tax law. Still, they contribute to higher returns and save you tax today. In New York specifically, your contributions are free from both state and city taxes, meaning you’ll get an instant savings of about 10% on any amount that you contribute.

Easy to set up and manage

To set up a 529 college savings plan, all you need to do is set up a plan account online or contact a financial advisor. You can make investments automatically by connecting your 529 plan to your bank account. The account is largely managed by the program manager of the investment company you have enrolled with.

Flexibility

Some people argue that 529 plans are rigid but you have several options for spending the money. Did your child decide not to go to college? You can change the beneficiary to another child, relative, grandchild or even yourself (for those college classes you wanted to take in retirement).

If you change your investment objectives or your beneficiary, you can always change the details of your 529 plan. You can change your investments twice a year and your beneficiary once a year. You can rollover your 529 plan once a year, too.

Why a 529 plan is a bad idea

A 529 plan can be a bad idea for many reasons, the most major being that it may prevent the student from receiving financial aid. A 529 plan may also narrow down your investment choices. Here are some reasons why a 529 plan is a bad idea:

Less financial aid

When colleges are deciding whether or not to give a student financial aid, depending on a few variables they will include the 529 college savings plan in the assets of the parents.

So while it’s true that the more assets you have as part of the 529 college savings plan, the less the financial aid you will be able to receive, if you’re building wealth I’m not sure how you’ll escape this problem by putting the money in other accounts. If you want to be rich, expect that you won’t be eligible for financial aid when it’s time to send your kids to college.

Penalties

As mentioned earlier, 529 college saving plans have certain restrictions on the number of withdrawals and the types of expenses that are eligible. If you do not abide by these rules, the government will charge you a 10% penalty and you will have to pay federal ordinary income tax (i.e. a non-qualified withdrawal).

However, this sounds worse than it is. First, you only pay federal income tax and penalties on the earnings portion of the 529 non-qualified distribution. That’s because your contributions were already subject to federal income tax.

Second, the money has been growing tax-free for years and would be subject to federal income tax on the gains anyway (the big difference here – and this is important – is that in a taxable account you would have only been subject to capital gains taxes and a non-qualified 529 distribution will subject you to ordinary income taxes).

So while the penalty and federal taxes are not ideal, it’s not like the government confiscates your money entirely. You’ll still end up with significantly more money than you initially invested in the accounts.

Limited investment choices

Since the states run 529 college saving plans, you may have limited options for investment given by each state. There is a list of investment options you need to choose from, such as age-based portfolios, static fund portfolios, and individual fund portfolios.

You can explore the investments available in your state by using the tool at the top of the page.

What happens to the 529 if the child does not go to college?

If the child does not go to college, you can always use your 529 for other types of education. You can use the 529 savings account for any post-secondary institution that qualifies for student aid. Some options are as follows:

  • Associate degree programs
  • Trade schools
  • Vocational schools
  • K-12 education
  • Community college
  • Certificate programs
  • Selected golf academies

Many people wrongly assume that a 529 only applies to four-year college programs, but in reality, it can be used for other kinds of education and career training.

If that option does not work for you, you can always change the beneficiary of your 529 college savings plan. This can be done once a year. If a child who is not your family member lives with you for most of the year, they can still be your beneficiary.

You can also withdraw the money for purposes other than qualified expenses. Some of these purposes may include disability expenses, unemployment, or medical expenses. In such circumstances, the IRS may waive the penalties.

Even if you choose to withdraw non-qualified expenses without special circumstances, you will only be taxed for the earnings proportion of the withdrawal. You will want to account for penalties when you do that.

Another option would be to leave the money in the account. Your child may not go to college now but may change their mind in a few years. Alternatively, you may decide to go back to school, or another related circumstance may arise.

How do you invest in a 529?

To invest in a 529 college savings plan, you need to compare savings plans, go through the fees, and make the decision between a prepaid plan and a college savings plan. You will then choose your investments. Here are the steps you need to follow:

Step 1

Go through your state plans using the tool at the top of the page. You are not obligated to choose a plan administered by your state, but doing so will entitle you to state benefits such as tax deductions. Therefore, you should consider the plans in your state.

Step 2

Go through plans that are not part of your state using the tool at the top of the page. Some plans administered by another state may have better fees. You should compare the fees of all the plans you have studied and choose one that has the most benefits. Directly sold 529 plans are priced differently than those sold by brokers.

Step 3

Decide between college savings plans and prepaid plans. Though the investment decision depends on your objectives, the state you are in also comes into the question. Very few states offer prepaid plans. As mentioned, prepaid plans limit your college options while saving plans do not and therefore prepaid plans rarely make sense.

Step 4

Choose an investment option. Once you have picked a plan, you need to choose from some investment portfolio options. You can choose between mutual funds such as stock funds or municipal securities, or you can choose different options, such as certificates of deposits.

Some things to consider in this step are the number of years till the beneficiary goes to college, whether you want to choose your investments, and the hassle you are willing to go through.

Personally, I choose the most aggressive investments possible in my 529 plan. I see the 529 plan as a chance to be aggressive with my portfolio. By taking on the risk I am hoping for a higher reward but it also won’t be the end of the world if the 529 account does not perform well as we have other assets to assist with college tuition if needed.

Step 5

Start investing. The earlier you start investing, the more money you will have when the time for college arrives. You can also choose automatic investment plans to withdraw a set amount of money from your bank account regularly.

Final thoughts on 529 plans

A 529 college savings plan is a tax-advantaged plan that helps account owners save up for their children and grandchildren’s higher education expenses. A 529 plan is useful because of its tax benefits and investment options. The account owner can change the investments and the beneficiaries of their plan, offering flexibility and ease.

A 529 college savings plan does have some limitations. You can only use the earnings you make through this plan for certain expenses. This, at times, can lead to penalties but those penalties might be overblown.