A 101 Class on 529 College Savings Plans

Photo: Pixabay

May 29th is National 529 Education Savings Day (5/29, get it?!) A 529 savings account offers lots of advantages for college savings, and a couple things you might want to be aware of before you dive in. 

‍What is a 529 account?

These are savings and investment accounts that allow you to put money away to pay for Qualified Education Expenses. 529 plans are run by individual states, and these programs are blessed by the IRS to allow the money to be tax-free if used for qualified education expenses. Fortunately, there are a lot of potential qualified expenses, though some of them like room and board have unique rules. From a psychological and planning standpoint, the 529 helps you earmark money ahead of time for college instead of having to go out of pocket for everything, and from a tax perspective there can be a great savings here. Let’s talk more about it:

1. Tax-Free Savings - The big 529 advantage is tax-free growth of your investment contributions. Let’s say you put $10,000 into a 529 when your child was born. At age 18, that could grow to almost $30,000 with a 6% rate of return. In an ordinary brokerage account that $20,000 in growth would be subject to capital gains tax, but in a 529 when used for qualified expenses, the full balance is available tax free! In addition, the dividends and interest the account earns annually is not reported either. It’s a valedictorian level win!
2. Flexibility in Expenses - As mentioned above, 529 accounts can go beyond just tuition. Books and supplies, fees, even computers and software needed for college coursework can potentially be a part of the equation. University housing and even off-campus housing can also be a qualified expense, but subject to certain rules and limitations. Your 529 plan might be able to pay for more than you think!
3. You Don’t Have To Stick With Your State’s Plan - 529 plans are state run, but you don’t have to use the money in that state. Your state may offer a state tax break to contribute to the home plan, but do the math as sometimes the deduction is rather small. Different state plans will have different investment options, different account managers, and importantly different sets of fees with their funds. I look for a low cost plan with a wide range of investment options, weigh it against any tax break the client might get in their home state, and usually recommend the plan that helps keep costs low.
   • Also, beware of expensive “advisor sold” 529 plans where the funds have high expenses. “Direct sold” plans typically have low cost investments, lots of index funds, and offer the same ability to choose and manage investments. Certain plans like the Utah my529 plan offer advisors like me the ability to support clients with account opening and investment management, while still maintaining some of the lowest expenses in the industry.‍
4. ‍‍Large Contribution Limits - Have a big chunk of change to put away at once? 529 plans have total balance limits but no annual contribution limits. Those total balance limits are very high, over $500,000 for some state plans. So if you received a nice bonus this year, or if grandma and grandpa want to gift a big contribution all at once, a 529 will help you do that.

What if I have leftover money?

One of the main concerns from investors around a 529 is overfunding the account. And there is some legitimate concern here as withdrawals that come out of a 529 that are NOT used for qualified expenses are subject to both a tax on earnings AND a 10% penalty. Trying to predict college costs that are 18 years away, with a variety of schooling options, scholarships, etc. is no small feat. So how do we avoid getting stuck with leftover money and penalties?

1. Fund Your 529 Conservatively - I typically discuss with clients what kind of college experience they want to plan for (in-state, out-of-state, private) and aim to fund 50% - 67% of the expected cost from the 529. That helps keep things conservative, and there are lots of other accounts we can fund college from such as savings or a brokerage account. We review the progress of the 529 account each year, and can always slow or stop funding if the account is getting too big for it’s goal. ‍
2. Keep It For Graduate School - Graduate school is where the real costs of college kick in, and the good news is that you can use your 529 for that too. So if Timmy got a full ride to state school for his pre-med degree and you barely touched the 529, great! That money will come in handy for med school, an MBA, law school, or whatever is next up. 
3. Give It To Another Beneficiary - A great benefit of 529 plans is the flexibility of changing the beneficiary. The list of beneficiaries you can transfer to without tax and penalty is long and includes siblings, parents, cousins, even in-laws. You can even keep the funds in the child beneficiary’s name and allow them to pass the funds on to one of their children in the future. So if your child finishes school and you still have 529 assets, it shouldn’t be difficult to find a loving, tax-free home for those funds.
4. Roth Contributions - New legislation passed in December 2022 opens up the possibility of transferring a portion of 529 funds into a Roth IRA for the beneficiary. This is still a very new provision and hasn’t seen much use in practice yet. If it sticks around it means a graduate with leftover 529 money could potentially use those funds to make Roth IRA contributions up to the annual limit, up to certain lifetime maximum limits. It’s complicated and shouldn't be the first plan for 529 funds, but it’s a nice option if you do wind up with excess money and want to shift a portion to a retirement asset. 

So there you have it, a quick run down of some of the considerations of a 529 college savings plan. It is important to evaluate the need to pay for college against the other goals you have for your plan including retirement. If you are looking for a way to save on taxes and be better prepared when your child gets their admission letter, 529 plans can be a crucial piece of the puzzle. 

Speak with a financial professional who can help you assess your current financial situation before investing on your own. More detail on IRS tax benefits for education can be found in IRS Publication 970.