Originally Published August 15, 2023 to include new insights and visuals.
When it comes to saving for college, the question usually isn’t if you should save -- it’s how. 529 plans are often the first answer that comes to mind. But are they really the best fit for your family?
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.
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.
👍 State Income Tax Deductions:
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.
👎 Inefficient Tax Relielf:
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.
👍 Tax Deferred Gain:
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.
👎 Not All Expenses Are Covered:
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 plan, even it is education related. Room & board and a personal computer may be allowed, but only in some situations (such as being enrolled at least half-time). Food and maintenance are not a qualified expense.
👍 A+ for Estate Planning:
529 plans have a great estate planning concept built into them, especially for grandparents. 529 plan contributions are treated like completed gifts, and a grandparent can accelerate up to 5 years of gifting in a 529 plan for a "superfunded" plan. If a grandparent owns and funds a 529 plan, the funds can't be counted against the student for financial awards.
👎 529 Money Can Count Against You:
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.
👍 Can Be Used for K-12 and More:
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.
👎 High Fees:
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 custodian 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. If you're considering ways to save for college, let's connect.
Information and Disclosures regarding 529 Plans:
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses, summary prospectuses and 529 Product Program Description, which can be obtained from a financial professional and should be read carefully before investing. Depending on your state of residence, there may be an in-state plan that offers tax and other benefits which may include financial aid, scholarship funds, and protection from creditors.. Before investing in any state's 529 plan, investors should consult a tax advisor. If withdrawals from 529 plans are used for purposes other than qualified education, the earnings will be subject to a 10% federal tax penalty in addition to federal and, if applicable, state income tax.