If there’s one thing that everyone can agree on these days, it’s that a college education is expensive. (It may be the only thing we can agree on.) So if you’re expecting Junior to chase that degree, and want to help give him a leg up, you’ll want to start planning early. Investing in a 529 plan can help you provide for those dreams. Now I know what you’re thinking, a 5-2-what?
A 529 plan (named after its section of the IRS code) is an investment account offering tax breaks that allows you to set aside money for qualified educational expenses—think things like tuition, fees, books, and room and board. Let’s dive into the details!
How Does a 529 Plan Work?
Most 529 plans are run by states, and there is one prepaid plan (more on that in a minute) run by a bunch of private colleges. Each 529 plan account has an account owner (often, though not always, a parent) and the beneficiary (the student). The owner controls the investments and chooses the beneficiary, which could be themselves. Anyone can contribute to a 529, and there are no income or age limits on contributions. And while most people associate these plans with saving money for their kids’ college education, as of 2020, you can now use the money in some 529 plans for K-12 public, private, religious school tuition, and apprenticeship programs.
While most people associate these plans with saving money for their kids’ college education, as of 2020, you can now use the money in some 529 plans for K-12 public, private, religious school tuition, and apprenticeship programs.
529 Plan Tax Benefits
Like some retirement accounts, you make contributions to a 529 with after-tax dollars, and the earnings are tax-deferred. That means qualified distributions (aka the money a beneficiary takes out) for a 529 are completely tax-free, and you can even get a tax deduction or tax credit in 35 states!1 And y’all know I love the words “tax-free.”
While you have to pay a “gift tax” if you contribute more than $15,000 ($30,000 for a couple giving together) in one year, you can get around that by doing what’s called five-year gift tax averaging. What this means is that over a five-year period, you can give in unequal amounts up to $75,000 ($150,000 for a couple). Let’s say you give Junior $20,000 in years 1–3 for a total of $60,000. In years four and five, if you only contribute $7,500 per year, you’ll be at that $75,000 limit over the five years and qualify for the gift tax averaging, and the IRS doesn’t get a cut!
Like some retirement accounts, you make contributions to a 529 with after-tax dollars, and the earnings are tax-deferred. That means qualified distributions (aka the money a beneficiary takes out) for a 529 are completely tax-free.
Types of 529 Plans
Now there are two basic types of 529 plans you’ll want to know about: prepaid plans and savings plans. There are some pretty important differences between these two, so be sure to focus here.
A 529 prepaid plan locks in tuition at current rates, so you can prepay future college costs. Today, there are 19 prepaid plans, but only 10 are accepting applicants.2 With the way tuition is rising this seems like a pretty good deal. Before you’re shouting, “Sign me up!” you might want to ask yourself why don’t all states offer them? Well, that’s what they call a red flag, people! You need to understand the increases in college costs can outpace the return on the prepaid plan. So you may have to shell out more cash to cover the tuition costs. Some prepaid plans offer guarantees, but some states don’t honor the guarantee. Listen up, this could mean the money may not be there when your child is ready to use it!
Experts say to plan for an annual 8% average tuition hike, which means tuition costs would double every nine years, or double twice from birth to college age!3 That means if the tuition today is $50,000, it would be about $200,000 18 years from now.
Benefits of a Prepaid 529 Plan
You can buy units, or credits, at participating schools (usually public and in-state).
There are no annual contribution limits, but you could have to pay a federal “gift tax” if you contribute more than $15,000 in a year.
There are no age limits for contributions or using the money in the prepaid plan (in most states).
Drawbacks of a Prepaid 529 Plan
Tuition rate may not be guaranteed.
Can’t be used to pay for future room and board.
Doesn’t let you prepay for K-12 tuition.
Has residency requirements for the owner and/or beneficiary.
You can’t transfer the money to a child of the beneficiary (your grandchild) if your kid doesn’t end up going to college.
May charge an enrollment/application fee and ongoing administrative fees.
Bottom line: Steer clear of prepaid plan options.
A 529 savings plan allows you to choose a predetermined investing portfolio that you can use to grow money for your child’s future educational expenses. You can reallocate the money within the portfolio you choose, but only twice a year.
The SECURE Act, passed in December 2019, created new qualified expenses for 529 savings plans. That means money in your plan can now be used for apprenticeships, homeschooling expenses, and repayment of up to $10,000 of student loans for the beneficiary and their siblings.4
With a 529 savings plan, you can shop around and see if 529s from other states have better investment options and lower fees. My best piece of shopping advice is to work with an investment pro who knows these plans better than anyone.
Benefits of a 529 Savings Plan
Each savings plan varies from state to state, and you don’t have to use your state’s plan.5 You can go with the most affordable plan!
There are no annual contribution limits, but you may have to pay a federal “gift tax” if you contribute more than $15,000 in a year.
There’s no age limit for contributions or distributions. If your 30-something decides to go back to school, they can still use the money.
There are no income restrictions for contributions or distributions.
Growth and withdrawals are not subject to federal income tax if used for qualified educational expenses, including tuition and books.
If you don’t use the money for one child, you can transfer the funds to another child or grandchild.
If you want to use money in a savings plan for noneducational expenses, you can. It’s your money! But nonqualified withdrawals are taxed and hit with a 10% penalty. Oh, and the person who receives the distribution pays the tax.6
Drawbacks of a 529 Savings Plan
You cannot lock in tuition costs.
May charge an enrollment/application fee, annual account maintenance fees, ongoing program management fees, and ongoing asset management fees.
Is a 529 Worth It?
The tax-deferred growth and tax-free withdrawals for qualified expenses are attractive reasons to have a 529 plan. Another is the higher contribution rates that can reach up to $500,000, depending on the state.7 But obviously the two types of plans are not created equal here.
Investing in 529 savings plans with good growth mutual funds is the best way to go with a 529. Savings plans provide a better return by investing your money instead of locking in a tuition rate with the prepaid plan. Plus, with most prepaid tuition plans, the state will only refund the principal (not any interest you’ve earned) if your child decides not to go to college.
Now, in addition to 529s, when looking at college planning for Junior, you’ll also want to check out an Education Savings Account (ESA). When it comes to a 529 and an ESA, the strongest argument for an ESA is the virtually unlimited investment options.
Investing in 529 savings plans with good growth mutual funds is the best way to go with a 529. Savings plans provide a better return by investing your money instead of locking in a tuition rate with the prepaid plan.
Get With a SmartVestor Pro!
Of course, Uncle Sam loves fine print—so do your homework before you choose a plan. And no matter what you choose, you can’t go on autopilot. The best way to stay plugged in is to talk with one of our SmartVestor Pros. They’ll know the options in your state, including any tax breaks, and can help you make the choice that’s right for you.