Why Some 529s May Not Be The Best Choice for Your Kid
Updated: Jun 1
Not financial advice - your money, your choice
Imagine a future where your child graduates from college debt-free and skipping into adult life unburdened. Sounds like a fantasy? With a 529 plan, that dream can become a reality, but not all 529 options are created equal. Whether you’re a new parent or a grandparent looking to invest in your grandkid's education, this 5-point guide can show you how to turn your savings into educational rocket fuel.
In this post, we’ll explore:
529 basics and how they work
Prepaid Tuition Plans
529 Savings Plans
Tax advantages of 529s
Strategies to maximize contributions
Using 529 funds on eligible expenses
Ben Clarke: a COVID college grad
1. 529 BASICS AND HOW THEY WORK
The cool thing about 529 plans is that they usually come in different flavors for different situations and different kinds of people. The two main types are Prepaid Tuition Plans and Education Savings Plans.
Prepaid Tuition Plans are pretty much exactly what they sound like - with an added bonus. They allow parents, grandparents, family members, and others to prepay tuition at today’s tuition rates at eligible public and private colleges or universities. This helps with managing future tuition costs as those contributions are converted to ‘units’. Where I live, (Washington state) 100 units = 1 year of tuition at the most expensive state university.
Most states also guarantee the funds that you put into a prepaid plan will keep pace with tuition. Some Prepaid Tuition Plans offer contracts for a two-year community college, a four-year undergrad program, or some combination of the two. They can even cover 1-5 years of tuition. In some cases, the contract can be applied to graduate school tuition.
529 Prepaid Tuition Plans also require you or your child to be a resident of the state offering the plan when you apply. Some states also limit enrollment to a certain time of the year, kind of like open enrollment for health insurance.
If you were to have started a 529 Prepaid Tuition Plan in Washington in 2006, assuming that when your child was born, and then contributed $5,985 (annual tuition at the University of Washington then). Your investment would have grown to $12,559 over 18 years. That’s a 109.84% return on your initial investment!
However, if you were to have invested $5,985 into a 529 Savings Plan fund at the same time (assuming the fund is tracking the S&P 500 w/ dividends reinvested - 9.8% annually) then you would have ended up with $32,203. A 438.062% return on your initial investment! Even with the great financial crisis!
From Calculator.net
AND, as we’re about to explore, you could do a lot more with that dough in a 529 Savings Plan…
529 Savings Plans have quite a few differences from Prepaid Tuition Plans. With 529 Savings Plans, students of ALL ages can save for qualified college expenses which are not limited to just tuition.
If you want to use funds from a 529 savings plan for K-12 tuition, your time frame will be shorter than those saving only for college and those withdrawals may not be tax-free in your state. This will likely impact your risk sensitivity and investment choices to be more appropriate for those circumstances.
529 Savings Plans are also more flexible on where you can use the funds. Qualified withdrawals can be used at most colleges and universities throughout the country, including graduate schools, as well as at some schools, internationally.
Many states also offer at least one 529 plan without a residency restriction. For example, you can live in Florida, contribute to a plan in Washington, and send your child to college in New York. The thing to keep in mind here is that your state may offer state tax advantages to residents who participate in a local plan which you won’t be able to take advantage of if you decide to use an out-of-state plan.
The cons of using a 529 Savings Plan are few. One restriction is that, under IRS rules, you can only change your investment mix 2 times per year. 529 Savings Plans also don’t lock in tuition like Prepaid Tuition Plans, nor does the state guarantee the investments.
You also run the risk with most 529 savings plan investment options that you may lose value or that the investment may not grow enough to pay for college whereas where with a Prepaid Tuition Plan, you’ll know that you always have X amount of school paid for.
2. TAX BENEFITS
The tax benefits of a 529 are many but your mileage may be better if your state has an income tax. For federal tax, your 529 contributions grow tax-free and earnings are not subject to income tax when the time comes to withdrawals for qualified education expenses. Unfortunately, there is no federal income tax deduction on 529 plan contributions.
For state income taxes, most states with an income tax will allow a deduction from income or tax credit for any 529 plan contributions that you make when reporting income for state tax purposes. YAY! Most states allow any contributor to claim tax benefits on their return, not just the account owner.
3. STRATEGIES TO MAXIMIZE CONTRIBUTIONS
The best way to maximize the returns in a 529 plan is to start yesterday. The second best way is to start today. Each day that you wait to save, you miss out on potential earnings and will have to put in more money to meet the same goal. As a general example, parents with a 4-year-old child who would like to cover 100% of college will have to contribute $200 more per month than if they had started contributing as soon as the child was born.
Setting up automatic contributions is another great way to maximize a 529. The set-it-and-forget-it mentality is the same that Netflix and Amazon have leveraged to become multi-billion dollar companies.
Looking for plans with low fees can also make a big difference. Fortunately, many 529 program managers like Vanguard and Fidelity offer low-cost investment options for college savers. The 529 Plan Fee Study is a helpful resource to compare the costs of direct-sold investment plans.
Thirty-four states and D.C. offer residents a tax deduction or credit for 529 plan contributions. In many cases, you have to use a 529 plan in your own state but seven states offer a benefit for any contributions made to any 529 plan. These tax savings can also be reinvested which will help your investments grow more over time.
Ask for gifts! Whenever a friend or relative asks what gift to get for your child, let them know about your 529 plan. With tax-free compounding, even a modest gift can grow significantly over time. Many gifting platforms are available that make it super easy to give via a 529.
Once your baby is out of diapers and daycare and into school (assuming public school), then you can use that money to increase 529 plan contributions! You can also allocate a portion of bonuses, tax refunds, work bonuses, or other windfalls into the 529.
Another strategy is to hold stocks & index funds in the plan for longer. A common strategy is to keep a 529 heavily weighted towards equities for 5-10 years before switching over to an age-based portfolio. This can have a great impact on return while reducing risk.
4. USING 529 FUNDS ON ELIGIBLE EXPENSES
Qualified expenses for 529 Savings Plans cover a broad range of educational costs. These include tuition, fees, room and board, textbooks, and computers if required by the school. Additionally, fees and equipment related to apprenticeship programs are covered, making these plans versatile for various educational needs.
For Prepaid Tuition Plans, the focus is primarily on tuition, but some plans may also cover certain fees. It's important to note that while Prepaid Tuition Plans guarantee the cost of tuition, they typically do not cover other expenses like room and board.
When using funds from a 529 Savings Plan for K-12 tuition, up to $10,000 per year can be withdrawn without federal tax penalties, although state tax treatments may vary. For college expenses, withdrawals are tax-free when used for qualified expenses, providing significant tax advantages over time.
Moreover, 529 Savings Plans offer flexibility in terms of where funds can be used. Qualified withdrawals are permitted at most accredited post-secondary institutions nationwide and some international schools, ensuring that students have a wide array of educational opportunities.
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