Going to college is seen as a major achievement and often as a pathway to a better future.
But in the US, the price paid for gaining a college education remains a source of concern for most people. Steadily, tuition increases have outpaced household incomes forcing families to rely on student loans to help foot the bill.
Yet, this seemingly easy way out has become a massive roadblock to financial freedom. The shift to “high-tuition, high-aid” has caused a “massive total volume of debt,”
Around 44 million Americans owe a combined $1.7 trillion for their education. Student debt is the chief culprit that has stagnated the financial growth of younger people. Millennials and Gen Xs are postponing the achievement of life milestones such as buying a new home, car, or getting married just to pay their student debt.
For parents that want to provide their kids with the education they deserve and escape the mountain of debt, a 529 plan is a good way to start with. In this article we dissect this little utilized college savings plan.
You can fully understand its benefits and drawbacks and decide if it is suitable for achieving your child’s college dreams.
What is a 529 plan?
A 529 plan is a government-sponsored investment program that lets you set aside money for college costs and a beneficiary.
With this strategy, you can:
- invest in high-yield assets
- defer paying taxes on capital gains while they are in your account
- then withdraw their earnings tax-free for eligible educational costs
Section 529 of the Internal Revenue Code permits donations to grow tax-deferred and withdrawals to be made tax-free if used for qualified school expenditures such as:
- tuition
- accommodation
- board
- textbooks
College-related costs, such as computers, and software that will be mostly utilized in the classroom also qualify as educational costs. 529 plans can also be used to pay for approved apprenticeship programs and K–12 tuition at private schools, not just for college.
Every state has at least one 529 plan. The majority of them offer a tax break or credit for donations made to the plans.
Even if you contribute to a plan in another state, certain states will still allow a deduction. Withdrawals are only taxed if utilized for other purposes other than educational expenses.
Types of 529 plans
529 Plans for Education Savings
This is the most popular type of 529 plan.
The Educational Savings 529 plan was initially intended to cover only the costs of postsecondary education, like college tuition. But in 2017, the Tax Cuts and Jobs Act (TCJA) increased its scope to include some K–12 education-related expenses.
Following the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, which permitted participants to use the funds to pay for approved apprenticeship program costs and repay up to $10,000 in student loan debt, its scope was then further broadened.
529 Prepaid Tuition Plans
Prepaid tuition plans are the other form of the 529 plan which allows you to pay for future tuition at participating colleges and institutions at today’s rates.
In most cases, state governments fund these programs. The prepaid plans, however, cannot be utilized for elementary or secondary schooling and do not cover room and board like 529 education savings plans.
4 Advantages of using a 529 plan to save for college
Tax benefits
If you donate a 529 plan, you may be eligible for a tax deduction or credit in many jurisdictions. If you utilize the money for qualified educational expenditures, your investments will grow tax-deferred and your withdrawals will be tax-free, including on your federal income taxes.
Most states provide a state income tax deduction or credit for contributions made to qualified 529 plans, and many states additionally exempt qualified 529 plan dividends from taxable income. A 529 plan is the only college savings option that offers state tax benefits.
States may have residence limitations for tax benefits, but families are not limited to using the college savings plan in their home state. If they are paying their tuition in advance, there might be an exception.
Low maintenance
You can open a 529 plan account online or through a certified financial advisor. Families can choose an automatic investing plan connected to a bank account or payroll deduction plan if they prefer a “set it and forget” approach. A program manager usually handles the ongoing investment management within a 529 plan.
High contribution limits
In contrast to other savings plans like a Roth IRA or Coverdell Education Savings Account, 529 plans offer large aggregate limitations and no yearly contribution limits. The maximum combined restrictions range from $235,000 to $529,000, depending on the state.
Contributions to a 529 plan are regarded as finished gifts to the chosen beneficiary for taxation purposes. Up to $16,000 can be exempt from gift tax annually in 2022.
Additionally, if the contribution is treated as if it were spread over five years, there is an option to contribute up to $80,000 in a single year without creating a taxable gift.
Flexibility
Regardless of household income or contribution level, 529 plans provide the same benefits to all families. Almost all 529 plans allow for investments, regardless of where you live or where your child will attend college.
Disadvantages of using a 529 plan to save for college
Investment choices can be limited
You might be able to invest in a variety of different assets through a 529 plan, such as money market accounts that are FDIC-protected and stock and bond funds.
Many states also have target-date funds, which change the composition of your investments to make them less risky as the time to use the money draws nearer.
However, 529 plans are managed by each state separately. Depending on which plan you select, they might not present an appealing investment opportunity. For instance, some state plans might only include a small number of expensive funds or high-cost funds.
That can be a considerable drawback when compared to putting the money in more alluring things like individual stocks for those with investment knowledge. To be able to invest in these other possibilities, it might even be worthwhile to pay taxes in a taxable account.
529 plans are not the same
State plans are illogical, both literally and metaphorically.
While the 529 plan’s general structure may be obvious—tax-free distributions for qualified investment expenditures, for instance—a great deal of what happens inside each state’s 529 is up to the state.
These may also vary:
- the types of investments you can make
- the charges associated with those investments
- the minimum contributions
- the overall administration of the 529 programs
You will need to spend more effort to comprehend how one state plan differs from another and what the tradeoffs are for each due to all these differences. Finding the proper 529 plan for your requirements is crucial, though.
May get penalized
The 529 plan regulations are strict.
The most important one is that you have to use money from a 529 account to cover eligible school costs. If not, you will be responsible for paying taxes on investment gains. This is the standard IRS rate plus an additional 10% penalty.
Even with the best of intentions, it’s possible to unknowingly incur a penalty even if the requirements may seem simple to understand and apply.
For instance, a parent may choose to withdraw the entire tuition for the academic year in fall.
Since the next semester falls the next calendar year, it means he would only have to make a single payment in the year of withdrawal. The withheld money for the next semester may be subject to ordinary taxes and the bonus penalty.
Could count against you for federal aid
Saving for college is expensive enough, yet the decision to be more financially responsible for your kids’ future could count against you. The 529 assets count against the account holder when applying for a financial aid package.
The greater the assets in the plan, the less aid is available from grants, loans, and financial scholarships.
The severity also varies by account holder. Assets in a parent-owned 529 account may ding the family’s expected contribution amount by 5.64%. A student who owns the account might take a hit of 20%.
Distributions from grandparent-owned 529 plans reduce eligibility for financial aid by as much as 20% until the 2024-2025 school year. Then they would no longer need to be reported as untaxed income according to the Free Application for Federal Student Aid (FAFSA) 2021 regulations.
High transaction costs
529 plans have higher expense ratios when compared to other options which you can use to save for your kids’ education. Your state 529 plan may have higher transaction costs compared to other options such as ETFs or bond funds.
The high expense ratio of 529 plans nibbles into your gains. Higher-cost funds might charge you 0.5% or more annually, or about $50 for every $10,000 invested. That might not seem like a lot, but low-cost funds today are priced under 0.1% or $10 for every $10,000 invested.
As your contribution grows, you’ll be paying more each year for the fund. This expense eats into your returns over time. Savers also have to be wary of the minimum monthly requirements needed for the fund, which may be beyond the reach of low-income families.
Bottom Line on the 529 Plan
Saving for a college education, one of the most important decisions you can make is to start today.
By beginning early, you’ll give your money time to compound. That’s where a huge share of your account value will come from over time. A 529 Plan is a good option, only if you are ready to overlook higher expense costs and reduced eligibility for financial aid.
But it helps give the assurance that you have put away something for your kids’ college. If you want to explore alternatives to 529 plans, you can check here.
