529 plans, named after the IRS code section that governs them (oh yeah… you can already tell this is gonna be a riveting one!), are relatively new. So for many of us who are in the stage of life where we are thinking about the best ways to save for our children’s college education, 529 plans weren’t really even around for us. The following is a quick and dirty summary.
529 plans allow you to put after-tax money into an account to be invested. This account grows tax-deferred, meaning it is not subject to capital gains taxes while the funds are in the plan, huge tax advantage. Funds drawn out for qualified higher education expenses, which can include, tuition, room, board, books etc, can be drawn out tax-free. Because of these features, some people compare 529 plans to Roth IRAs. (Like a Roth IRA for college expenses)
Bill and Tina just had their first child, Sam. They begin putting away $300/mo away into a 529 plan faithfully until wrinkly-newborn-Sam turns into 18-year-old leaving-the-house-for-college Sam.
- Total $$ deposited into account: $300/mo x 12mo/yr x 18 yrs = $64,800
- Moderately aggressive growth rate of 7% per year
- Total Tax free $$ available for college when Sam hits 18 = $129,216.31 (which sounds like a lot… but won’t be enough if you plan to cover all costs… FYI)
- Tax free earnings = $64,416!!
If Bill and Tina had used a regular investment account to do their saving, they would have come out with AT LEAST $9,600 less to work with due to capital gains taxes. Of course, as with many financial vehicles, there are pros and cons. Here are just some of them:
- Tax-free earnings if funds are withdrawn for qualified higher education
- Parents or account owners retain control of assets – This means that little junior cannot take the money and blow it over spring break. Account owners get to keep investment and distribution discretion throughout the life of the plan.
- Beneficiaries can be changed – If Sam got a full scholarship and didn’t need the funds, the account could be changed to benefit another child, niece, nephew, or even future grandchild.
- Anyone can contribute – If grandparents, aunts, uncles, etc would like to make monetary gifts, they can also contribute to the same plan.
- Some states allow you to deduct your contribution from your state income taxes if you buy your state’s sponsored plan – Click here to see a list of which states currently allow this benefit.
- Can be prefunded – Using the 5-year election, parents or grandparents can use up to 5 years of their gift exemption to pre-fund a 529 plan to allow for maximum compounding. This is a little more advanced and I can dig in to this later if I get enough interest/inquiries about how this works.
- Can also be used for graduate school – If Junior decides to become Dr. Junior, and didn’t eat up all the account funds through undergrad, it can be used for graduate school expenses as well.
- Funds must be used for qualified higher education – So if you happen to raise an artist, or kid that just generally has other plans, you lose your tax benefit
- Funds withdrawn for other purposes subject to penalties – Not only will the funds withdrawn for reasons other than qualified higher education expenses lose the tax benefit, they are subject to heavier taxing and penalties. Earnings would be subject to INCOME taxes (vs. capital gains in a normal investment account) and a 10% penalty on top. They do this to discourage people from abusing this awesome savings tool.
- 529 Plan providers tend to be in flux – Each state sponsors a 529 plan and each provider only has a contract with each state for so long. Now and then, the contract gets rebid. This means that you can start with one provider you like, and automatically get moved to a different provider at the mercy of the state’s renegotiations.
- Cannot be used for private junior high or high school tuition
- Trade schools are generally not included
- Only some community colleges are recognized
- 529 Plan assets can be counted against your qualifications for financial aid
So the question is, should you be using a 529 plan? You can make a decision based on the pros and cons above, or stay tuned for another blog entry in the works comparing just a few of the other ways you can save for college, and some of my opinions on them (Hint: the 529 is not my fave!). As always, I welcome your thoughts and questions!