You hear it all the time – “College isn’t getting any cheaper!” In fact, college tuition rates typically rise at twice the rate of inflation. So that glass jar on top of the fridge marked “college fund” isn’t going to cut it. Sorry, someone had to say it. But this is where a 529 Savings Plan comes to save the day.
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What is a 529 Plan?
529 Plans refer to section 529 of the Internal Revenue Code giving tax benefits to certain education savings programs. And if you’re curious, section 528 of the IRS Tax Law is about taxation of Homeowners Associations, but that’s not important right now. A section 529 Plan allows for savings for college costs to be tax-deferred and distributions not taxed at all if used for qualified higher education expenses and now K-12 tuition.
There are actually two types of 529 Plans: College Savings Plans and Prepaid Tuition Plans.
College Savings Plans are the more popular option as they are more flexible and cover more education costs. Like retirement accounts, you can typically buy investments within a 529 Savings Plan such as mutual funds and target-date funds with all the risks and rewards associated with them.
Then when you need the money, you sell your investments and use the proceeds toward things like tuition, books, room and board, or computers. And as long as they’re qualified education expenses, you have no tax bill at the end.
Prepaid Tuition Plans are different. Instead of buying investments with your contributions, you are prepaying future tuition and fees at today’s prices. As mentioned earlier, this may be appealing considering tuition rates have historically risen much faster than inflation.
So if you believe that tuition rates will outpace the growth of any investments in a 529 Savings Plan, you may want to consider this. However, this plan only covers tuition and fees. You’re on your own to cover other non-qualified educational expenses.
Again, College Savings Programs are much more popular and many more states offer them so the remainder of this article will only cover the savings plans.
How It Works
Think of 529 College Savings Accounts like a Roth IRA for college education.
You invest with after-tax money, and it grows tax-deferred. Then it’s all tax-free at the end if you use it for college expenses at any qualified educational institution, including vocational schools.
Since it’s like a Roth, you don’t get a federal income tax break on what you contribute. However, your state plan may give you a state tax deduction or even credit.
More on that later.
In Even Simpler Terms
I know that with a lot of finance articles, in the name of completeness, we have to use a lot of financial terms like “tax-deferred,” “asset allocation,” or “after-tax money.” But sometimes it helps to get a picture of exactly what will happen in plain terms. So with as little finance-talk as possible, this is loosely what happens with most 529 Savings Plans:
- You call someone or visit a website. Usually it’s your state’s 529 plan, but you can also use any other state’s plan.
- You tell them that you want to open an account for someone or multiple people (you’re going to need their social security numbers).
- They say, “Great! Here’s how much in any minimum amounts you have to contribute (if any). We can probably set up automatic deposits from your bank account.”
- Then they give you a list of things you can invest in with the money you’re going to deposit. Usually they’re index funds, target-date funds, or mutual funds – safer things for your investment portfolio.
4a. If you’re lucky enough to live in a generous state, you can take your state’s tax deduction for your contributions each year.
- You wait… and you watch. And hopefully your money quadruples… and your kids stay out of any real trouble until college age.
- All your kids get into Harvard with no financial aid.
- You call your plan back all sweaty and panicked and tell them to sell some of your investments so you can have cash funds to write some massive checks.
- Come tax time – nothing. You shouldn’t owe a penny of taxes on any of it. Hallelujah!
- Pity the fools… I mean, commiserate with your kid’s classmates’ parents who (unlike you) have to take out massive student loans.
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Some More Awesome Details
Deductions. As I mentioned earlier, in addition to federal tax advantages most states also offer a state tax deduction for your contributions if you participate in their 529 plan.
For this, in most cases, the plan has to be your own state’s plan. However, some (7) states actually give you their state income tax deduction even if you join another state’s plan. You lucky Arkansas… -onians(?)
Credits. What’s even better than a deduction? Any tax accountant will tell you it is a tax credit. Briefly, a tax credit does not simply deduct the amount of income you’re taxed on. It’s an actual reduction on your bottom-line tax amount.
So while a deduction from your state taxable income reduces your state tax by just your state tax percentage rate, a tax credit will reduce it dollar-for-dollar of the credit amount! Some states actually offer you a tax credit for at least a part of your 529 contributions (normally about 20%).
Grants. What’s even better than a tax credit? Any Civil War buff will tell you it is a grant. (Okay, sorry for that, but U.S. History majors are busting a gut right now). Some states, to encourage participation in their 529 plans, offer matching grants to residents with new accounts.
Though this is usually for account owners under a certain income threshold. Not many states offer this and not every year, so you have to look for them. For example Maryland has a College Investment Plan through T. Rowe Price that had a program like this.
One of the reasons 529 College Savings Plans are so flexible is how easy it is to move your funds around as your situation changes. You can rollover funds between different 529 accounts once every 12 months with no tax liability.
You can change the beneficiary of a 529 Plan to another family member as much as you’d like with no tax liability. If you have a child with a disability who qualifies for a 529 ABLE account, you can rollover funds from a regular 529 account to that as well.
Some Not-As-Awesome Details
This is the thing that holds most people back from getting a 529 plan. If you don’t use your 529 plan or if you use it on non-educational expenses, you not only owe taxes on your gains but also a 10% penalty on those gains. However, the specter of these taxes and penalties is actually much scarier than the reality.
If you had saved this money in a regular investment account or even a simple savings account you’d have to pay similar taxes on the gains. And the federal tax penalty is only on the gains, not the entire amount.
So if you had invested $1000 and it grew to $1500 ($500 in gains), your penalty would be $50. In fact, in a regular savings account you are taxed on your gains each year. In a regular brokerage account, you are taxed on any dividends each year. And if you understand compounding interest, you know that this annual taxation saps its power.
The specter of taxes and penalties on 529 plans is actually much scarier than the realityTweet This
Limited Investment Options
If you look at most 529 plan investment catalogs, it’s usually made up of a couple of index funds, perhaps some low-cost mutual funds, and more likely a lot of target-date funds. If you’ve ever seen the investment choices in a typical 401k, you’d say they look pretty similar.
But 17-18 years is not a very long time-horizon and these boring diversified funds are there to probably save you from yourselves more than anything. You don’t want to bet junior’s future on Bitcoin.
Some Final Thoughts
Financial Aid Eligibility
You may have heard that 529 accounts reduce any financial aid your child may get. Again, this is a situation where the reality is not as bad as what savers assume.
On the financial aid application, a 529 account held by a custodial parent is only counted as an asset. This means that a maximum of 5.64% of the value will be counted against any financial aid need (similar to any savings or checking account).
So if you had $10,000 in the account, it would only decrease your aid by around $560 total.
And by the way, that jar on the fridge? Same deal. If you had $10,000 in that thing it would also decrease your financial aid by $560. Also, what are you doing keeping that much cash on top of the fridge anyway? Uncle “Sticky Fingers” Joe is coming over.
Roth IRA Alternative?
You may have also heard that if you’re not sure that your kids will go to college, that a Roth IRA could serve double-duty as a college fund. This is because you can always withdraw Roth contributions tax and penalty-free.
There are a couple of problems with that. One, any amount taken from your Roth contributions is considered untaxed income on your financial aid application, which is counted much harsher against need than assets. And two, you’ll be depleting your retirement fund, which you can’t go back and replace beyond the annual contribution limits.
Which brings us to a final point. Though college may not be getting any cheaper, neither is retirement. I read somewhere that there’s this amphibian that will feed its offspring its own flesh to help it survive. This is noble (if not a bit extreme) but not a model to imitate.
As a last resort, your child can get student loans. Amphibians can’t get student loans, and you can’t get retirement loans. So you should fund your retirement before saving for your little tadpole’s college dreams.
Saving for college pro-actively and riding the current of investing is much better than taking out student loans later and struggling against it.
Okay, so you’ve decided that there’s a pretty good chance at least one of your kids will go to college, your retirement saving is on cruise control, and you want your college fund to do more than collecting dust bunnies in your kitchen. Great!
You can go through a 529 Plan broker like CollegeBacker for a one-stop-shop option, or you can go directly to a 529 Plan offered by a state. Some find brokers more flexible and easier than their specific state plan.
The difference is that with a plan broker, you won’t be able to claim the state tax benefits if your state offers it. If you want to select your own 529 Plan, savingforcollege.com has wonderful tools to help you find one.