529 Plan: The Best Way to Save for College
There’s very little doubt in my mind that the best way to save for college is to use a 529 Plan. I recently talked to a friend about it and showed him why the wrong decision could cost him $40,000!
His current financial advisor told him the 529 plan wasn’t the best way to save for college for his young daughter, and instead, he should pay for it with after-tax investments.
WHATTTTTTTTTTTT
That was my first reaction. There might be a few reasons not to use a 529 plan, but I wanted to dive deeper into my friend’s situation to see if there was a reason not to use a 529.
His current advisor gave him a couple of reasons why the 529 plan wasn’t the best way to save for college:
What happens if your daughter doesn’t go to college, and your money is trapped?
What happens if your daughter gets a scholarship?
If you’re not familiar with the 529 plan, these can seem like reasonable deterrents, but you know these aren’t dealbreakers if you’re familiar with them.
529 Savings Plan Overview
The 529 plan started as a college savings plan and has since added K-12 tuition. There’s a lot of flexibility in who can set them up, contribute, change beneficiaries, and even various investment options.
The most significant appeal of the 529 plan is many states offer tax incentives on contributions, and all states allow the earnings to grow tax-free. You can use this tax-free money to pay for qualifying education expenses.
529 Savings Plan Background
Congress passed Section 529 in the Small Business Job Protection Act in 1996. I’m surprised they’ve been around for so long because many people don’t know about them.
Even though congress created the plan, 529 plans are sponsored by the states and authorized by the IRS. Each state can create its own set of rules governing the 529 plan, but they can’t change certain federal benefits.
Due to state management flexibility, 529 plans get more confusing when you dig into them. Each state has its own 529 plan offering, with some states partnering with each other.
However, the overall gist is the same; the accounts encourage savings for future education costs through tax advantages and incentives. They don’t allow any federal tax benefit for contributions as they’re all post-tax, but they allow earnings to grow tax-free and tax-free spending on qualified distributions.
Choosing a 529 Plan
It doesn’t matter which state you live in or where your kid (or beneficiary) goes to college. You can live in Utah, open up a Texas plan, and pay for a college in California.
Each state’s plan varies in regards to investment selection, maximum contribution, and management fees. The significant variable is if you’ll have state tax incentives.
According to Savings for College, 30 states offer a tax deduction or credit, and seven states provide the tax benefit even if you contribute to an account in another state!
These seven generous states are Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.
All remaining states either don’t offer or a tax incentive or only provide the incentive for state residents who contribute to their state’s 529 plan.
Here are the steps for picking a 529 plan:
As the 529 plans are different for each state, this does require a little research, but the information is readily available. Here’s a great place to see state-specific information.
What should I look for in a 529 Plan?
If the flow chart takes you all the way through “Yes,” it’s an easy decision, sign up with your state plan. If it doesn’t, you have the “freedom” to choose, making it a little more challenging. Here’s what you should do:
- Research plan fees by state
- Determine which type of investments you want (Age-based or set portfolios)
Saving for college has a great tool to help you decided.
Who should I name as the beneficiary?
There are many confusing things about the 529 plan, but the great thing is they’re very flexible. A plan can only have one beneficiary, but you can change the beneficiary up to two times per year.
However, there are no limits on how many 529 accounts you can set up, so generally, if you have more than one kid, you should set up multiple accounts.
There’s a lot of flexibility here, too, as you can roll funds out of one account into a new account without any tax consequences.
Some brilliant people have even figured out how to create a “family dynasty” plan for education savings that can be passed down multiple generations with minimal tax implications when done correctly.
Who can contribute to your child’s 529 plan?
529 plans allow “third-party contributions,” so nearly anyone can contribute to your child’s 529 account. Are you tired of your kids receiving Christmas gifts that have a two-week useful life? See if they’ll give 529 contributions instead!
Once again, it differs by state, but some plans provide an electronic platform for gifting or even 529 gift cards.
Contributions to 529 plans are considered gifts, so gift tax and generation-skipping transfer taxes due apply. However, you generally won’t have to worry about paying any tax if your total estate is under $11 million or $22 million for a couple.
If you have this problem, I’m sure you already have a team working on it.
The current gift tax exclusion number is $15,000, so as long as you gift under that amount to a beneficiary per year, this won’t count against your gift tax number.
If you want to give more, there’s a one-time “5-year” contribution allowed, which is currently $75k per beneficiary, that will enable you to contribute five years worth of 529 upfront without impacting the gift tax.
The 5-year contribution requires annual reporting, and states can claw back some out if the grandparent passes within the five years, so do your research before committing to this.
What happens if my kid doesn’t go to college?
You’ve heard me preach flexibility enough to probably realize your money isn’t lost if your kid doesn’t go to college.
The first thing to think about is that all of the original contributions were post-tax, so you can take your contributions out without tax or penalty. However, there could be consequences on your state taxes if you received incentives.
Besides possible repayment of state taxes, it’s only the earnings you have to worry about on non-qualified distributions. For all profits removed and not used for a qualified expense, you’ll pay regular income tax and a 10% penalty.
This penalty might sound familiar as it’s the same treatment as if you pulled money out of an IRA or 401(k) early. It’s not necessarily a dealbreaker.
However, there are options to change the beneficiary or roll the funds into a new account instead of removing the money.
What happens if my kid gets a scholarship?
It’d be terrible if your kid received a full scholarship, and you couldn’t use your 529 plan, right?!
In reality, it’s a great problem to have, and guess what – the 529 plan has the flexibility to deal with this.
If the beneficiary receives a scholarship, you’re allowed to remove that portion of the 529 amount without penalty or tax!
What are the qualified distributions for the 529 plan?
You can use the 529 plan to fund up to $10,000 per year in tuition for K-12 schools, and the qualified distributions for college expenses open up even more.
You can use 529 plan funds to cover the following college expenses:
- Tuition and fees
- Books and supplies
- Computers and internet access
- Room and board
- Special needs equipment
- Student loans
In general, qualified distributions cover most college expenses besides “extracurricular” activities. Sadly, this means if I had a 529 plan in college, I could not have paid for my spring break trip to Las Vegas.
Is the 529 plan worth it? A case study:
The best way to see the value of the 529 plan is to get into the numbers. Let’s refer to the example we started with to see if the 529 plan is worth it.
This example is a resident of Georgia with a young daughter. Georgia allows joint filers to deduct up to $8k from their state taxes for 529 contributions.
- Total amount saved with a 529 Plan : $317,000
- Total amount saved by using an after-tax account: $276,600
- Difference: $40,400
That’s right, the decision not to choose a 529 plan could cost my friend over Forty Thousand Dollars!! Here’s how I came up with the numbers:
- 529 Plan contribution: $8k per year
- Contribution length: 18 years
- Investment Return: 8%
- Total Investment: $300,000
Extra tax incentive provided by the 529 Plan:
- Annual savings via tax deduction (Georgia): $460/year
- If you invested this amount for 18 years @ 8% return = $17,000
Tax savings on long term capital gains for qualified education expenses:
- Total investment value (calculated above): $300,000
- Of this, $156,000 are investment earnings
- In an after-tax account, these earnings could be taxed between 0 – 20% based on income
- If we assume 15%, there would be $23,400 due in capital gains!
That means this family would have $40,000 less available for expenses if they decided not to use a 529 plan and instead use their after-tax investments!
529 Plan Conclusions
The 529 plan offers many reasons to save for college, including upfront tax incentives, tax-deferred growth, and tax-free withdrawals for qualified distributions.
It can easily save you tens of thousands of dollars per kid, depending on how much you contribute. It’s worth spending the time to research which plan is best for your situation and start using it!
