529 Plans Are the "No Brainer" College Savings Vehicle
529 Plans Are Your Friend
I’m often surprised by the level of skepticism I hear regarding 529 college savings plans.
The 529 plan allows for easy investment choices, tax free growth and tax-free distributions to pay for college. With an early start to funding, this can create tens of thousands in savings for a family over the many years leading up to college.
Despite what I feel to be a “no brainer” for many families, I’m always met with skepticism regarding 529 plans. In this article I’ll explain why 529 plans are so beneficial and answer some common questions and concerns.
First, here’s how they work.
Mom, Dad and/or grandparent open a 529 plan and name their child as beneficiary. Contributions to the account are automatically invested in an aged-based portfolio that become more conservative over time.
With steady contributions and investment growth, the account becomes a substantial source for college savings leading up to Junior's first year. When it’s time to pay for college, parents take distributions from the 529 plan.
The distinction between this account and any old savings or investment account is that the 529 plan allows investments to grow tax free. This is similar to a Roth IRA. The account is funded with taxable money (no federal tax deduction on contribution), but there are no investment taxes (capital gains, interest or dividends) to report year-to-year, and when parents take distributions to pay for tuition—those distributions are also TAX FREE.
Parents should not ignore the benefits of tax-free investment growth. Even with a 5% annual compounding return, this would allow contributions to double in just over fourteen years. When 529s are funded with a lump sum in a child’s early years, the compounding effect is even greater, and so are the tax advantages.
But What If My Kid Doesn’t Go to College?
I hear this one all the time. It’s absolutely a valid concern, but it’s highly unlikely parents would find a way to NOT use 529 funds on their loved ones. And even if they do, they simply have to pay the tax + a 10% penalty on investment growth only.
This is another case of evaluating what we know today to assign some probability to a future event. In this case, the future event is “needs qualified higher education expenses”, and when we consider the breadth of the category “higher education expenses” we see that it’s VERY LIKELY to occur.
For those that don’t go to college, this includes things like trade school, online college, cosmetology school, beauty school, or even (sports dad nightmare) art school.
Private high schools also qualify, with some limitations.
And if one child absolutely has no chance of ever needing higher education because they’ve become a YouTube celebrity or Instagram influencer—just use the funds for another child.
There is a very high chance that you can find something or someone to use the funds for. In today’s world it would have be somewhere around 90%.
If you don’t, sorry, but you’ve still netted money on saving all these years. Yes, this is the WORST-CASE SCENARIO for investing in a 529 plan—you have to pay tax and a penalty on the money you’ve made from saving and investing over the years.
Despite the great tax benefit, it’s amazing how many people let the 10% penalty on investment growth prevent them from making a totally rational economic decision.
But Won’t This Affect Ability to Receive Financial Aid?
It could, but if done correctly, it won’t. Assuming the student uses the Free Application for Federal Student Aid (“FAFSA”), there are some things to consider. FAFSA looks at parent and student assets and income to determine the “expected family contribution” (“EFC”). While the 529 plan is generally considered an “investment” for the parent, distributions are generally NOT considered “income” for the parent or the student.
The inclusion of this asset will reduce available aid, but not to the point where it outweighs the overall tax benefits or THAT IT’S AN ASSET SPECIFICALLY EARMARKED AND INTENDED TO PAY FOR COLLEGE AND SHOULD PROBABLY REDUCE AVIALABLE AID. Just saying.
What About 529 Plans Owned by Grandparents?
This gets a little tricky. Distributions from a grandparent’s 529 plan ARE considered income and can drastically increase a student’s EFC. Luckily, there’s a fairly simple way to avoid this.
The easiest way to plan for this is to, if possible, withhold distributions from the grandparent 529 until after January 1 of the student’s sophomore year. FAFSA looks back two calendar years prior, so any FAFSA analysis for junior or senior year, then, will not include distributions from winter semester of sophomore year.
While I’m generally not in the business of using federal tax dollars to subsidize the inflated college costs for clearly well-to-do families, these are just the rules and any good financial planner should know them.
Can We Use It for Private High School?
Yes. One of the changes to the 2017 Tax Cuts and Jobs Act was that 529 plans can be used for public or private elementary, middle, of high school with a maximum of $10,000 per year, pers student.
Is My Contribution Tax Deductible?
At the federal level, no. You may be entitled a deduction at the state level. For instance, in Massachusetts, the first $2,000 of contribution is deductible for those married filers filing a joint return—at a 5% tax rate this amounts to a whopping benefit of $100 per contribution. But again, this is a distant ancillary benefit to the main benefit—tax free investment growth and distributions.
Why Wouldn’t I Use A 529 Plan?
With how broad, useful, easy, and economically viable these plans are—I really don’t know. If you can say with reasonable certainty that education expenses are unlikely for your children, then certainly do not use one. For most people, though, this is a no brainer.