Pay for Your Kid’s College: 529 Savings Plans

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Around the time my kids were born, 529 Savings Plans were going through various mutations to become what we know today – a way to save after-tax money to pay for college expenses. While we haven’t saved hundreds of thousands of dollars in these accounts, we’ve managed to put away enough to pay for the majority of their educational expenses at an in-state public college.

What is a 529 Savings Plan?

529 plans provide parents, grandparents, and others with the opportunity to invest after-tax money in various investment options to pay for the named beneficiary’s (the child’s) college expenses. This money is allowed to grow tax-free until the time at which it is withdrawn. No taxes or penalties are deducted if the money is used for approved college expenses. Additionally, many states offer an income tax deduction or credit for 529 plan contributions (differing limits in different states).

Benefits

In addition to the tax savings and the potential for tax credits, 529 plans offer other benefits.

Easy to use. Most states offer at least one 529 plan, with the option of choosing individual funds, target date funds, or other combinations of investment options. As with a retirement plan, you can set up the plan to automatically invest at intervals that make the best sense for you.

Fees. Many plans started with higher fees but have since realized they need to be competitive in this arena to attract money. While you may receive a tax benefit by investing in your home state plan, you aren’t required to keep your money in-state. There are websites that detail the “best” 529 plans (including those with lowest fees) that may help counterbalance any tax savings or credit you’d receive in your home state. In other words, don’t be scared to shop around for the best fees and investment options.

Minimal effect on financial aid. If the plan is opened by a parent, it is seen as an asset of the parent, and no more than 5.64% of the value of the account is counted against financial aid eligibility.

High contributions allowed. The lifetime limit ranges from around $250,000 to more than half a million dollars, depending on the state. This is substantially more than the annual $19,500 limit on 401k plan contributions. But that makes sense, since you usually have only 18 years to fund your child’s account versus the 40 years you might have to fund your retirement. Make sure when you are contributing that you don’t run into the gift tax limitations.

Flexible. 529 accounts offer a high level of flexibility, including the opportunity to roll the account to another child if the named child decides not to go to college. There’s no time limit on using the funds, so you could potentially save for your child and keep any leftover funds invested for your grandchildren down the road.

Disadvantages

Like any government tax-savings plan, there are rules to using these plans.

Fees. Yes, this can be an advantage or a disadvantage. Many plans offer investment options that function essentially like index funds, including the reduced fees that those investment options offer. Yet others may offer targeted funds with higher fees. It’s up to you to pick the plan and funds that minimize your fees while helping you reach your savings goal.

Investment options. I touched on this briefly, but unlike investing in an IRA with your broker, you probably won’t have the world of investment options open to you in a 529 plan. With my plan, I was disappointed to see the lack of options in stock-only investments. There essentially was one stock market fund that I could choose. However, after receiving the state tax credit and watching fees, it was still the best option for my money.

10% penalty. If you use money in the 529 for qualified educational expenses, you pay no taxes or penalty. However, if you withdraw money for other purposes, you will pay both taxes and a 10% penalty. Note that the tax payment is only on earnings since you invested with after-tax money.

Hard to play catch-up. Most kids start college at 18. That gives money invested in a 529 plan a limited amount of time to grow. Waiting until your child is in high school probably won’t produce the returns you’re hoping for.

529s can be worth the hassles

Before you decide to jump in, do some research on your state plan. Find out if your state sponsors one of the better plans in the US and also determine if you can receive a state tax deduction or credit for your investments. Then look closely at your plan options and fees – are there funds you’d feel comfortable investing in at a cost that’s attractive to you?

I live in a state where initially you received a $2,000 credit for money invested in a 529. It has since changed to a $8,000 state tax deduction. While the funds weren’t perfect, I still had a 100% stock option at a low cost. With one child in college, I have managed to save enough to pay for her first two years and have plenty left over for the remainder of undergrad and at least a year of grad school.

Photo by Yan Krukov

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