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529 Plan: What Is It and When to Leverage

College tuition is expensive.

The average cost for an in-state public school is $20,770 per year. Private college tuition costs $46,950 per year. And they keep going up every year.

If you have young kids today, you can expect these numbers to be significantly higher when it’s time to pay for your kids’ or grandkids’ education.

If you’re planning to put money into a college fund, a 529 plan will be a top option to consider.

What is a 529 Plan?

A 529 plan is a tax-advantaged investment savings plan for education expenses. While the program was initially intended for post-secondary education, the Tax Cuts & Jobs Act of 2017 added K-12 public, private, and religious schools to the list of qualifying purposes.

There are two types of 529 plans:

  • 529 Savings plans — Savings plans are only offered by states. Savings are typically held in mutual funds but can be held in stocks, ETFs, or other investment vehicles. These work similar to an IRA, where the intention is to invest money for the long-term. The idea here is to maximize gains while reducing risk for the target date when the beneficiary will be attending school.
  • 529 Prepaid Tuition plans — Prepaid tuition plans allow you to lock in current rates of tuition at specific schools. This protects you from the rising costs of education and inflation between now and the time the beneficiary attends a qualified school. You can prepay for one or more semesters at a time.

The exact terms of individual plans vary by state. Check to see what your state offers before finalizing a decision.

How a 529 Plan Works and What Are The Rules

Any resident of the United States who is 18 or older can open a 529 plan. There are no restrictions on income levels. You just need to have a valid mailing address and a social security number or tax ID.

The beneficiary of a 529 plan can be any US resident with a social security number.

So if you’re planning to open a college savings account for your child, you need to wait until they are born first. The beneficiary of a 529 plan can even be the same person who opens the account, although this is not as common.

529 plans do not have annual contribution limits. However, these plans do have maximum aggregate limits, which vary by state and program. Federal law prohibits a 529 plan from exceeding the costs of the beneficiary’s expected expenses for education.

Examples of qualified 529 plan expenses include:

  • Tuition costs
  • Room and board
  • Books
  • Supplies
  • Computers and other equipment required by the school
  • Special needs service expenses incurred with enrollment or attendance

College application costs, testing (SAT/ACT), college prep courses, and transportation costs are not qualified 529 expenses. In the past, you couldn’t use a 529 plan to pay for student loans. Now you can use it to pay $10,000 worth of qualified loans.

Distributions from a 529 plan used for unqualified expenses are subject to income tax and a 10% early distribution penalty. These penalties are waived under the following circumstances:

  • The beneficiary dies
  • The beneficiary becomes disabled
  • The beneficiary receives a qualified scholarship, military educational assistance, employer-assisted educational benefits, or other nontaxable payments for educational expenses

The beneficiary of a 529 plan can be changed to another qualified family member at any time without incurring a penalty or taxes.

The Benefits of a 529 Plan vs. Other Investment Vehicles

529 plans are eligible for tax advantages. Contributions are not deductible at the federal level, but the earnings grow tax-free. Funds won’t be taxed when the money is eventually used to pay for qualified expenses.

More than 30 states offer full or partial tax deductions for contributions toward a 529 plan. Check the terms for your local state and speak with a tax advisor to maximize those deductions.

As the donor of a 529 plan, you have full control of the account. The beneficiary does not have any legal claim to the funds, which is different from UGMA and UTMA Custodial Accounts. In these instances, the recipient has a claim to the account when they reach legal age.

The top benefits of a 529 plan include:

  • Tax-free growth
  • State tax deductions
  • Withdrawals are not subject to taxes or capital gains
  • Low maintenance
  • Easy to set up
  • Ability to change beneficiaries without penalty
  • Flexibility (donors can change the investment options twice per year)
  • No eligibility restrictions based on income
  • Simple tax reporting
  • The same child can be the beneficiary of multiple 529 plans

A 529 plan is like an IRA. Except instead of using the funds for retirement, the money will be used for a beneficiary’s educational expenses.

The Disadvantages of a 529 Plan

529 plans are not perfect. There are some potential drawbacks that you should keep in mind before you consider opening a 529 savings account.

  • Limited investment options — Some 529 plans restrict the type of holdings you have. In addition to the limited selection, adjustments to holdings can only be made two times in a calendar year. Depending on the state, investments are limited to specific fund families.
  • High fees — 529 plans typically have higher management fees than other savings and investment vehicles. Earnings on conservative holdings can potentially restrict the account’s growth.
  • Taxes and penalties — Withdrawals not used for qualified education expenses are subject to income taxes and a 10% penalty. This can be a problem if you’re presented with an unexpected financial crisis and need to come up with money fast.
  • Financial aid eligibility — 529 plans are considered an asset. This could affect a student or parent’s ability to qualify for financial aid. The student will have fewer chances to receive federal grants, subsidized loans, and work-study opportunities.

Time is your best friend when setting up a 529 plan. The sooner you start, the more compounding interest you’ll have. That will have an enormous impact on the final balance and you’ll save a ton of money in taxes.

Setting up a 529 just a few years before paying for college comes with more drawbacks than benefits.

Other Options to Consider

Is a 529 plan the best way to save for college? It depends on your state, financial situation, plan, and who you ask. But 529s are not the only way to start saving for college.

These are the best alternatives to a 529 plan:

Custodial Accounts

Custodial accounts are controlled by the parent or account holder until the beneficiary reaches legal age, which could be anywhere from 18, 19, or 21 depending on your state.

UGMA and UTMA custodial accounts do not have annual contribution limits or restrictions based on household income. However, the beneficiary of a custodial account cannot be changed.

Funds in a custodial account are not limited to educational expenses, so no penalties will be incurred if the money isn’t used to pay for college. Earnings in a custodial account are taxed at the beneficiary’s tax rate.

Savings Accounts

A traditional savings account is another way to save for college other than a 529 plan.

The returns on contributions to a bank savings account will be minimal, but the money can ultimately be used for any purpose without a penalty. Unlike mutual funds, exchange-traded funds, or stocks, savings accounts are less risky in the short-term and won’t be subject to losses.

If you’re opening a savings account to pay for college, look for a high-yield savings account to get the best interest rate.

Roth IRA

To be clear, a Roth IRA is a retirement account—not a college savings account. But with that said, it can still be an appealing way to pay for college, depending on your situation.

As of 2019, the maximum annual contribution to a Roth IRA account is $6,000, and $7,000 if you’re over the age of 50. The earnings in a Roth IRA grow tax-free.

You can withdraw contributions at any time, penalty-free. Investment earnings can be withdrawn after the age of 59 ½ without triggering taxes or penalties. If your child is attending college after you reach this age, you can use the money from your Roth IRA account to pay for it.

This is not a conventional way to use a Roth IRA, and I wouldn’t recommend it unless you had another retirement plan with sufficient funding.

Coverdell Education Savings Account (ESA)

A Coverdell ESA is a tax-deferred trust account that can be opened for beneficiaries under the age of 18 to pay for future educational expenses.

Multiple Coverdell ESAs can be set up for the same beneficiary. However, the maximum annual contribution is $2,000 per beneficiary, regardless of how many accounts they have.

Contribution earnings in a Coverdell ESA are not taxed until the funds are distributed.

How to Open a 529 Account

Opening a 529 account is easy. The entire process can be broken down into just five simple steps:

Step #1: Choose a plan — There are hundreds of 529 plans available. First, decide if you want a savings plan or a prepaid plan. Next, consider your choices in-state. You could always set up a 529 out of state, but this likely won’t be your best option if you want to maximize in-state tax benefits.

Step #2: Set up an account — In most cases, a 529 plan can be opened online. Just find a broker that offers the program you want and fill out the appropriate form on their website. You could always print and mail an application, or visit a local broker in-person as well.

Step #3: Select the beneficiary — This will likely be your child or grandchild. Make sure you have their Social Security number ready or you won’t be able to open the account.

Step #4: Fund the account — You can fund a 529 plan using an electronic transfer from your bank or by mailing a check. After the initial funding, you can set up automatic contributions from your bank or automatic payroll deductions from participating employers. Check to see if your state has minimum contribution amounts.

Step #5: Choose your investments — This can be as simple or as complex as you want to make it. It all depends on how much risk you want to take. Usually, people invest a 529 plan into a target date fund. This starts off aggressive but eventually shifts to more conservative investments as the beneficiary approaches college age. It also does everything automatically so you don’t have to rebalance the portfolio yourself.

If you open a 529 plan online and fund it with an electronic transfer, the entire approval process can take less than 24 hours. Paper applications and mailed checks could take weeks to approve.

The Best 529 Accounts to Consider

Plans offered by your home state will be the most logical place to start your search. However, most states allow investors from anywhere to open a 529.

Depending on where you live and where you open the account, you may not be eligible for state tax benefits. But it’s still worth shopping around to see your options.

  • CollegeAdvantage (Ohio) — Ohio’s CollegeAdvantage 529 plan offers age-based portfolios, risk-based portfolios, and the ability to customize a basket of investments. The plan has a long history of above-average returns, low management fees, and tax breaks for Ohio residents.
  • NY’s 529 College Savings Program (New York) — Unlike other states, investment options here are limited to just one fund family. Fortunately, the company is synonymous with low fees and high returns—Vanguard. The program has three different age-based portfolios and offers the opportunity to customize your portfolio based on risk tolerance and goals.
  • Bright Start (Illinois) — Illinois’ Bright Start 529 plan provides investment options from 11 different fund families, making it one of the most diverse choices on the market. With a wide range of age-based portfolios, target portfolios, and custom portfolios, Bright Start has something for everyone.

If you’re looking for the lowest fees, consider these 529 plans:

  • ScholarShare College Savings Plan (California) — 0.09% fee
  • U.Fund College Investing Plan (Massachusetts) — 0.10% fee
  • Fidelity Arizona College Savings Plan (Arizona) — 0.11% fee
  • Delaware College Investment Plan (Delaware) — 0.11% fee
  • UNIQUE College Investing Plan (New Hampshire) — 0.11% fee

529 plans with the highest 3-year returns are:

  • National College Savings Program (North Carolina) — 30.91% return
  • NEST Direct College Savings Plan (Nebraska) — 14.16% return
  • CollegeAdvantage 529 Plan (Ohio) — 12.23% return
  • Vanguard 529 College Savings Plan (Nevada) — 12.22% return
  • CollegeAccess 529 (South Dakota) — 11.60% return

Overall, a 529 plan is one of the best investment vehicles for saving and paying for college. These plans offer plenty of benefits, including tax advantages like state deductions and tax-free growth.

It’s easy to set up a 529 account to start saving money for a beneficiary right away. Opening an account as early as possible is the best way to maximize investment gains.

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