529 plan is a tax-advantaged way to save for education. It's one of...
The Money Cruncher, CPA@money_cruncher
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Nov 27, 2024
~4 min read
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529 plan is a tax-advantaged way to save for education.
It's one of the best tools for investing in your child's future, yet 99% of people don't understand how it works.
Here’s what you need to know:
It's one of the best tools for investing in your child's future, yet 99% of people don't understand how it works.
Here’s what you need to know:
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529 plan offers 2 main benefits:
> Tax-free withdrawals for qualified education costs.
> Often state tax deductible (more on this in a bit)
> Tax-free withdrawals for qualified education costs.
> Often state tax deductible (more on this in a bit)
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For example, say you put $10,000 into a 529 plan.
Depending on the state, you will receive a tax deduction.
By the time your child (or even you) is ready for college, the amount may grow to $30,000. You can withdraw it without paying any taxes.
Depending on the state, you will receive a tax deduction.
By the time your child (or even you) is ready for college, the amount may grow to $30,000. You can withdraw it without paying any taxes.
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A 529 plan can only have one owner (also called a donor), so it’s very important to name a successor owner to take over the account in case of death.
Typically, people open a 529 plan under their own name or their spouse’s name and name their child as the beneficiary.
Typically, people open a 529 plan under their own name or their spouse’s name and name their child as the beneficiary.
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There are two types of 529 plans:
1. Prepaid tuition plans
2. College savings plans
1. Prepaid tuition plans
2. College savings plans
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Prepaid tuition plans allow you to purchase the cost of future college tuition at today’s prices.
The state guarantees that the value will keep up with tuition inflation.
The price you pay will vary depending on the student’s age and the tuition rates.
The state guarantees that the value will keep up with tuition inflation.
The price you pay will vary depending on the student’s age and the tuition rates.
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For example, you might make a one-time payment of $65,000 for four years of university.
When your child attends college, the tuition will be covered, even if the cost has risen to $100,000.
Prepaid plans are contractual obligations, so it's costly to cancel.
When your child attends college, the tuition will be covered, even if the cost has risen to $100,000.
Prepaid plans are contractual obligations, so it's costly to cancel.
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College savings plan are state-sponsored investment accounts.
Unlike prepaid plans, the investment returns depend on market performance.
Think of a savings plan as a typical brokerage account where you contribute funds and invest them in an X/Y fund.
Unlike prepaid plans, the investment returns depend on market performance.
Think of a savings plan as a typical brokerage account where you contribute funds and invest them in an X/Y fund.
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The investment options in the savings plan typically depend on the state/provider.
The most common option is an age-based portfolio, which diversifies funds and adjusts risk based on the child’s age.
These funds become more conservative as the child grows older.
The most common option is an age-based portfolio, which diversifies funds and adjusts risk based on the child’s age.
These funds become more conservative as the child grows older.
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So, which one is better?
From a numbers standpoint, it comes down to this simple question: “Do you believe the cost of tuition will increase faster than stock market returns?”
From a numbers standpoint, it comes down to this simple question: “Do you believe the cost of tuition will increase faster than stock market returns?”
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If you think the tuition will rise by 15% annually, the prepaid plan is superior.
If you believe market returns will outpace tuition growth, a savings plan is better.
If you believe market returns will outpace tuition growth, a savings plan is better.
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For example, tuition at Illinois public universities grew 49% (inflation-adjusted) from 2007 to 2022, while the S&P 500 returned 138% (inflation-adjusted) during the same period.
Although past performance doesn’t guarantee future results, it can be a useful indicator.
Although past performance doesn’t guarantee future results, it can be a useful indicator.
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In terms of flexibility, a savings plan is much better.
You aren’t committed to a specific contract.
You can contribute $500 a month today and stop tomorrow if needed.
This flexibility is one of the main reasons why people prefer savings plans over prepaid plans.
You aren’t committed to a specific contract.
You can contribute $500 a month today and stop tomorrow if needed.
This flexibility is one of the main reasons why people prefer savings plans over prepaid plans.
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However, prepaid plans provide certainty—you don’t have to worry about stock market fluctuations.
That said, some prepaid plans don’t allow attendance at out-of-state or private universities, so be sure to check the details.
That said, some prepaid plans don’t allow attendance at out-of-state or private universities, so be sure to check the details.
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A good rule of thumb for determining your annual contribution is to estimate the current net price for the university and contribute 1/5 of that amount each year.
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Using the University of Illinois as an example, the overall average net price for a year of school is about $20,000.
Our rule of thumb suggests an annual contribution of about $4,000, which is $20,000 ÷ 5.
Our rule of thumb suggests an annual contribution of about $4,000, which is $20,000 ÷ 5.
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The tax benefits depend on your state.
I suggest Googling your state name with 529 deduction to understand whether a deduction is offered.
If your state doesn’t offer tax benefits or doesn’t have an income tax, you can open a plan in a state that offers the best investments.
I suggest Googling your state name with 529 deduction to understand whether a deduction is offered.
If your state doesn’t offer tax benefits or doesn’t have an income tax, you can open a plan in a state that offers the best investments.
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With a 529 savings plan, you might run into the issue of over-contributing - where you save more than necessary, pay for the education, and still have a balance left in the plan.
If that happens, there are a few options:
If that happens, there are a few options:
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1. If the 529 plan has been open for at least 15 years under a beneficiary, you can convert up to $35k to the Roth IRA.
2. You can transfer the plan’s beneficiary to another relative.
3. You can withdraw the remaining balance, but you’ll pay taxes and penalties on the earnings
2. You can transfer the plan’s beneficiary to another relative.
3. You can withdraw the remaining balance, but you’ll pay taxes and penalties on the earnings
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2. retweet the first tweet
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