Are you a parent trying to save money to pay for your child’s education? One of the best financial moves you can make to save for college is opening a 529 college savings plan. This article will discuss what is a 529 plan and why it’s important to have one.
As college costs continue to skyrocket and a college degree can potentially cost $500,000 in the upcoming decades
What is a 529 Plan?
A 529 plan is a college savings account that allows you (the parent) to contribute money to a tax-free investment account when the money is used to pay for college expenses. You can think of it an “Education 401k” because of the generous contribution limits and you invest in a select number of ETFs or Mutual Funds.
The primary advantage of saving for college with a 529 Plan is tax savings. If you made the same investments in your normal taxable brokerage account, you would have to pay capital gains tax each year on dividends and when you sold the stock. Over the life of the investment, that can result in thousands of tax dollars paid unnecessarily.
Plus, you might be able to qualify for a state income tax deduction as well by contributing to your state’s 529 plan. Keep in mind that if the money isn’t used for college expenses, it will be subject to a tax penalty.
Advantages of a 529 Plan
Here are several reasons why you should start contributing to a 529 plan today.
- Most Cost-Effective Way to Save for College
- High Contribution Limits and No Family Income Restrictions
- Contributions Earn More Interest Than a Bank Account
- Can Invest in Guided Age Range Plans or Individual Mutual Funds
- Potentially Qualify for State Income Tax Deductions
Disadvantages of a 529 Plan
- Limited Investment Choices
- Subject to 10% Penalty if Contributions Not Used for College Expenses
How to Choose a 529 Plan
Nearly every state offers a 529 plan. And, you don’t have to sign-up for your state’s plan to use the funds in most instances. This can be extremely useful if your state 529 plan has high expenses or your child decides to attend an out-of-state college.
You can research state 529 plans or your investment brokerage might offer their own 529 plan.
Be sure to choose a 529 plan with low fund expenses & annual account fees. Higher investment fees will reduce the total available balance your child can use to pay for college by thousands of dollars potentially. Investment fees for 529 plans can vary between 0.10% and 0.70%, that can be a significant difference over 18 years of investing.
You may also decide to look at the funds within a particular 529 plan. Just as some company 401k plans have funds with lousy performance, your 529 can be the same way. Check the Morningstar ratings of some of the funds you are interested in. As a disclaimer, past performance never guarantees similar future results, but, it can be a good indicator.
Once you have narrowed your potential choices to 2 or 3 plans, weigh the tax implications of each fund. If you plan on living in your current state through your child’s college years, choosing your state 529 plan can mean an extra deduction at tax time!
How to Contribute to a 529 Plan
Unlike other types of college savings accounts, a 529 plan has high contribution limits that well exceed the cost of a normal undergraduate education. The good news is that and remaining money can be used for graduate school or transferred to another family member’s 529 plan. And, families of any income bracket can qualify for a plan.
When you are ready to start making contributions, you will need to use cash or check. Not gifts of stock or other tangible assets. Extended family and friends can also make contributions, but, when the annual contribution exceeds $14,000, the surplus is subject to a 529 gift tax.
Do 529 Plans Impact Financial Aid?
Another concern you might have is if 529 plans will disqualify you from receiving financial aid. The best way to minimize the impact of a 529 plan on the FAFSA (Free Application for Federal Student Aid) is to have the 529 owned in the parent’s name.
This is because the FAFSA only counts 5.64% of the parent’s assets but factors in 20% of the student’s assets. Not only does having a parental 529 plan increase your chances of receiving financial aid, but, it increases the flexibility of transferring any remaining funds to another child after your first child completes college.
What Happens When You Don’t Use a 529 Plan?
The worst nightmare of most parents (when it comes to 529 plans) is that their child will not go to college & use the money to buy a motorcycle or another “frivolous” non-educational purchase instead.
There are some safeguards for 529 plans. For starters, the plan is in the parent’s name. This means you have more say in how the funds are disbursed.
If they don’t go to college right away, you have three options.
- Keep the money in the 529 if they return to college in the future
- Transfer to another child without penalty
- Withdraw the money after a 10% penalty for non-educational spending
As long as you somehow use the money in the future for at least one person in your family, including you, the contributions can be spent without penalty. The third and final option is similar to cashing out your 401k before retirement, it’s possible, but, it will cost you to close the account.
If you want to make sure you have saved money for your child’s education, a 529 is probably the best option. While you do have limited investment options like your own 401k, choosing the cheapest plan with good mutual funds will yield high returns. Plus, you will save a good amount of money in capital gains taxes as well.
Even if you can’t save for the entire cost of college, a 529 plan puts you on the correct path.