Saving for college is a common financial goal among young families, and the earlier you begin, the easier the task (most often). The question of “Should I save for college” isn’t generally the question that’s asked, as many individuals already know if they want to save and pay for college for their children. The question is almost aways “How should I save for college?” As with any other financial planning endeavor, there are endless alternatives that are all viable options.
529 Plans are one of the most popular methods of saving for college, simply because they are designed to pay for college expenses. I feel many people automatically think that because 529 plans were created to pay for college that they are the only way to save for college. Or that a dollar inside a 529 plan somehow carries more value than a dollar outside a 529 plan. Whenever I discuss 529 plans, I generally spend ample time discussing alternatives to 529 plans – not because I’m against 529 plans or that I feel 529 plans are inherently bad, but I feel there are misconceptions about saving for college without a 529 plan.
Additionally, it appears there are benefits to having 529 plans and there are benefits to not having 529 plans. In this article, I’ll discuss some of the things I like and don’t like about 529 plans. When making financial decisions, most people focus on the benefits of any one decision, but when deciding on a 529 plan, I like to focus on the negative attributes; if the negative attributes don’t seem to be such a negative to you or it doesn’t pertain to you, then 529 plans are probably a good option. Side note: it’s also good to consider the benefits of 529 plans as this will help you become more educated about the decision overall.
What is a 529 plan? In short, a 529 plan is a college saving investment account with some tax advantages, which can vary by state. Contributions can be tax deductible against your state income tax (if any), and growth is tax deferred. If the funds are used for qualified education expenses, the proceeds, which may include investment growth, can be accessed without capital gains taxation.
This next section will feature a positive attribute of 529 plans followed by a negative attribute of 529 plans.
What I like about 529 plans:
State income tax deductions. This isn’t a game-changer, but it can be nice. In my state of Oklahoma, as an example, up to $20,000 of annual contributions can qualify for a state income tax deduction. Oklahoma’s state income tax is about 5%, so after contributing $20,000, you could get as much as $1,000 in state tax deductions. Of course, this varies by state. If someone purchased an out-of-state 529, there is no state income tax deduction (unless that person has income from that state). Additionally, not every state offers a state income tax deduction, such as Texas and Wyoming.
What I don’t like about 529 plans:
While $1,000 in tax relief is always welcomed, it takes a lot of contributions to unlock a small deduction. 529 plan contributions are treated as a completed gift, so the funds are not only illiquid, but the funds are unavailable to anyone other than the beneficiary (the beneficiary on the account can be changed). For a small tax benefit, you essentially lose control of the money.
What I like about 529 plans:
Investment gains inside 529 plans are not subject to capital gains taxation if the proceeds are used for qualified expenses. For the average investor, this is great news because the tax code on the investments is simplified: no tax. The sooner a 529 plan is established, the better, as the longer an account is established, the more time it has to grow. For those in the highest income tax brackets, the NIIT (Net Investment Income Tax) doesn’t show up in 529 plan assets.
What I don’t like about 529 plans:
To properly use a 529 plan without penalty, all expenses need to be used for qualified expenses. In short, you don’t have control on what you can purchase with a 529, even it is education related. For example, a college education is more than books and classes; it’s also learning to live on your own. Room and board aren’t considered qualified expenses. Neither is a personal computer, unless you are enrolled in a class that requires you to have your own computer, which is rare since most educational institutions have computer labs.
What I like about 529 plans:
529 plans have a great estate planning concept built into them, especially for grandparents. 529 plan contributions are treated like completed gifts, yet the contribution doesn’t count against the annual gifting limit. A parent or grandparent (or anyone else, for that matter) could contribute to a 529 to reduce their estate value and still can provide more benefit and estate planning gifting in addition to these 529 contributions.
What I don’t like about 529 plans:
Having a 529 plan owned by a parent or a beneficiary can self-select someone out of federal college aid, intuitional funding, and sometimes even scholarships. When paying for college, you can use your money, borrow money, or use someone else’s money (and not have to pay it back). The “someone else’s money” option is very valuable, and 529 plans can be counted against you when applying for using “someone else’s money” because you already have your own funds available. Important to note: this is not the case when a grandparent owns the 529 plan.
What I like about 529 plans:
Up to $10,000 per year can be used to pay for K-12 private school tuition, which allows the 529 plans to be more versatile than they used to be. 529 plans are also available to pay for trade school, law school, medical school, etc. 529 plans are generally considered to be used primarily for funding a four-year college or university, but they are broader in their usage.
What I don’t like about 529 plans:
529 plans can be expensive. There are a lot of institutions involved in 529 plans, especially state-sponsored 529 plans, and each institution gets paid from your account. If you purchase a state-sponsored 529 plan, the state treasurer benefits financially, generally by charging a maintenance fee, plus an internal fee on the account. Revenue is usually shared with the custodian of the plan (a custodian is the institution that keeps track of funds, trades, ownership, etc. An example of a custodian is Fidelity, Pershing, Schwab, etc.). Additionally, you can choose to pay an advisor to help manage the investments of the 529 plan, but if you choose a state-sponsored 529 plan, the investment selection will be limited due to the previous mentioned revenue-sharing between the custodia and state treasurer. The limited investment selection may limit an advisor’s value to the overall account.
In summary, 529 plans can be a great way to save for educational expenses, but there are some pros and cons to consider. There’s no one way to save for college that’s inherently better than another way, but like all other financial decisions, a little education on these accounts help put the 529 plan rules into perspective.