Introduction to 529 College Savings Plans
Thanks to recent actions by the United States Congress, 529 plans enjoy permanent...
Arguably, getting a college degree is one of the most expensive investments a person can make. The average 10-year historical rate of tuition increases is approximately 5%, and by the time the calendar rolls over to 2033, four years at a public university will cost nearly $100,000.
However, studies show that paying that expense is worth it. College graduates typically earn higher salaries and experience lower levels of unemployment than non-graduates, as per the College Board data showing that bachelor degree holders earnings are 65% higher than the median earnings of high school graduates.
So, the expense of a higher education can be worth it for many individuals.
Given the rising costs associated with college, many parents and grandparents have taken to task defraying these costs and reducing the amount of student loans their children/grandchildren must take on to pay for school. And there are many ways to save for college. One of the best ways to do so continues to be the 529 Plans. These savings vehicles are specifically designed for college savings and offer a host of benefits for users.
In the end, college can be expensive, but 529 plans make paying for the expense much easier.
Over the last decade, assets in 529 plans have surged by almost 140% to reach nearly $311 billion in total holdings as of June 2019. And there’s a good reason why the plans are some of the most beneficial for saving for college. It’s best to think of them in a similar fashion to 401(k) or individual retirement accounts (IRAs). And like those accounts, they offer the chance for tax-deferred or tax-free savings. The beauty of a 529 account is that investments in the savings plan are not subject to federal tax, as long as the money is used for college expenses.
The plans are sponsored by various states, and basically come in two flavors.
Investment accounts are the most popular variety. Here, savers select various sub-accounts that own a variety of stocks, bonds, real estate and cash holdings. These subaccounts generally own mutual funds or ETF holdings. And just like your retirement portfolio, the value of these sub-accounts can rise or fall as the market changes. By going this route, savers have the potential to increase the value of their account faster than estimated college costs.
Prepaid tuition plans offer participants to buy a future dollars’ worth of tuition expense for less money today. By placing money in the account, savers can lock-in a rate of return on their future tuition expenses based on a state’s crediting rate. However, given the limited portability – one states crediting rate may not match the tuition increases in another – these plans are not as popular as expected and many states have been closing their guaranteed plans. Tennessee was the latest example of this.
Plans can either be bought directly from sponsoring states or through broker intermediaries. The real difference comes down to who you send your check to. Whether it’s Fidelity or Legg Mason or the State of Ohio, some broker-sold funds do come with sales loads and other commissions, so it’s important to look at your total costs when selecting a plan.
Whether you choose a guaranteed or an investment account, the eligibility criteria for opening a 529 plan account are the same. Any U.S. resident who is 18 years or older and has a Social Security number or Tax ID can open a 529 plan. There are no income restrictions. The plans are tied to a certain beneficiary – or who you are saving for. Savers can contribute up to $14,000 per beneficiary in a single year or the account can be front-loaded by $75,000 in one year without the money being subject to the federal gift tax. Savers can only put a maximum of $500,000 per beneficiary into a 529 account.
Check out our state plans section here to learn about the rules and regulations pertaining to 529 plans for each U.S. state.
Perhaps the real reason why investors have been flocking to 529 plans over other vehicles for college comes down to their many benefits.
The chief of which is tax advantages. Investing in a 529 college savings plan will allow your savings to grow tax-deferred as long as the money remains in the account. Meanwhile, qualified withdrawals for higher education expenses – such as tuition, housing, books and required supplies – are free from federal income tax. Some 529 plans have an added benefit of reducing state taxes as well. Many plans will offer residents the ability to lower their current state income tax bill by making a contribution to their state’s 529 plan. This one-two tax punch is one of the main reasons why 529 plans have grown exponentially over the last decade.
But the plans offer other benefits as well. For one thing, assets in 529 plans aren’t counted in many student aid formulas and aren’t considered children’s assets when calculating scholarship formulas.
529 plans offer plenty of estate planning benefits as well. Contributions to a 529 plan are considered “completed gifts” that remove assets from a taxable estate. Secondly, investors are able to change beneficiaries of the 529 plan- to even yourself- at any time. This can create a legacy of tax deferred college savings for future generations. Finally, investors can place unneeded, but required minimum distributions (RMDs) from retirement accounts in a 529 in order to continue to shield assets from taxes.
These benefits make a 529 plan a superior choice to other college savings vehicles. For example, Coverdell Education Savings Accounts only allow a maximum contribution per year of $2,000, while balances must be withdrawn by the time the beneficiary turns 30. Likewise, Uniform Gift to Minors Account (UGMA) and Uniform Transfer to Minors Account (UTMA) offer pitfalls when it comes to asset determinations for student aid and scholarships. Regular cash savings and taxable brokerage accounts obviously offer none of the tax deferrals of a 529 plan.
However, there are some pitfalls that investors need to made aware of when looking at 529 plans over other savings vehicles.
For one thing, investment options tend to be limited. Unlike a self-directed brokerage account, you’re locked in to whatever investments the state sponsor has selected for the plan. Investors may be able to get higher returns elsewhere. Meanwhile, fees may be higher than a regular mutual fund or ETF.
Secondly, the accounts were designed for college expenses. As a result, using savings for other purposes can cost you dearly come tax time. The IRS charges a 10% penalty when money in the account is used for something other than qualified education expenses. Depending on residency, state and local taxes could also be added to the withdrawal. Additionally, if you overestimate your child’s education costs and withdrew more money than you needed, this 10% tax penalty applies to the overestimated amount if not used for qualified expenses. So, it’s imperative that you use the savings for college.
Want to learn more about mutual funds? Check out the mutual fund screener on MutualFunds.com to explore funds that meet your specific investment criteria.
College is an expensive endeavor. And one way to help defray the cost is through a 529 plan. These plans offer plenty of tax and estate planning benefits for savers and their beneficiaries. It’s no wonder why they have surged in popularity over the years. Checking under the hood is imperative before making a selection in your college savings plans, but the benefits of a 529 plan often outweigh the cons.
Be sure to check 529 Insights section here to learn more about 529 plans.