Have you considered opening a 529 Educational Savings Plan for your kid or future kid? 529 accounts help many families save for future educational expenses like college. They are a great fit for a lot of families but it is best to understand both the pros and cons of 529 college savings plans before opening one.
529 accounts are somewhat akin to a Roth IRA in that you invest post-tax dollars but your investment growth and withdrawals are tax-free. The catch is you have to use the funds for qualifying educational expenses in order to get the tax break.
I opened my 529 account with Wealthfront (referral link) a couple years before I was even pregnant. Opening the account early gives us a long investment horizon to maximize possible compound growth. If we didn’t end up having a baby, we could have used the funds for ourselves or gifted them to family members since 529 accounts bake in easy beneficiary changes.
Below you’ll find a breakdown of common advantages and disadvantages of 529 plans. Before diving in, remember that how you save for your kid’s future education and your tax situation are highly personal and will depend on your overall financial situation. This is an informational post and can’t say whether 529 college savings plans are right or wrong for you (or for what tax breaks you may or may not qualify).
- What is a 529 Account?
- Advantages of a 529 Education Savings Plan
- 1. Tax-free withdrawals on 529 account distributions
- 2. State income tax incentives for 529 contributions
- 3. Educational expenses include a lot more than just tuition
- 4. Easily change beneficiaries on your 529 plan
- 5. Many family members are eligible to be 529 savings plan beneficiaries
- 6. No deadline to use 529 account funds
- 7. High annual contribution limits to 529 college savings plans
- Disadvantages of a 529 Education Savings Plan
- 1. Inherent risk to investing, including 529 plans
- 2. Penalties if 529 savings are not used for education
- 3. You may be limited to state-sponsored plans to take advantage of state income tax benefits
- 4. 529 savings may impact future financial aid eligibility
- 5. 529 account contributions may face gift taxation
- 6. Some 529 plans have high fees
- 7. Most plans don’t offer an easy way for others to gift to your child’s 529 savings account.
- 8. You have to keep records of your educational spending
- 9. 529 savings may impact other educational tax credits
What is a 529 Account?
Before diving into the pros and cons of 529 plans, let’s go over the basics of 529 accounts. 529 accounts are tax-advantaged savings plans that can be used towards qualifying educational expenses. 529 college savings plans were formalized on a federal level in the 1990’s and get their name from the IRS tax code section that govern them – Section 529.
Starting a 529 account early in your kid’s life gives you the advantage of a long investment horizon and compounding growth. Also, depending on your state of residence, 529 savings plans may provide tax breaks through:
- States incentivizing family 529 contributions through state-income tax breaks.
- Federal taxes being waived on investment growth and distributions when used for educational costs.
529 college savings plans vary state to state. Your state may or may not offer state income tax incentives for contributing to educational savings.
Similarly, your state may offer different types of 529 plans. Many states offer a plan that is comparable to a traditional savings or investment account that you control.
Some states also run 529 plans that are sometimes referred to as ‘pre-paid tuition’ plans, where your contributions pay for future in-state tuition in that state. Here we are primarily focused on the more flexible savings account plan as these pre-paid options have limited availability and different considerations (like how sure you are that your kid will go to college and go to and in state school).
When you open a 529 account, you are the owner of the account and you designate who the beneficiary of the account is (the person whose educational expenses will be covered by the funds).
Here is generally how a 529 college savings plan works:
- You put in after-tax dollars into your designated 529 account.
- Your investment grows tax-free through your kid’s childhood until they are ready to use it for educational expenses.
- When it is time to start paying for your kid’s education costs, you use distributions from your 529 account which are tax-free when applied to qualified educational expenses.
Qualified educational expenses include costs like tuition, room and board, and supplies. Since the 2017 Tax Cuts and Jobs Act, 529 savings can also be applied to secondary school costs. You can find more about these changes on the IRS website.
Advantages of a 529 Education Savings Plan
In the section above, I briefly touched on the tax advantages of a 529 account. Those are just some of the pros to opening a 529 college savings plan. Here are 7 advantages that 529 accounts offer families.
1. Tax-free withdrawals on 529 account distributions
Any contribution you make to your kid’s 529 savings plan grows tax-free. You also aren’t taxed when you take distributions from the account when paying for qualified educational expenses. You can find a full list of what is considered qualified educational expenses in this IRS guide.
2. State income tax incentives for 529 contributions
Some, but not all, states offer tax breaks for families who contribute to a 529 account. In most states, you have to enroll in a state-sponsored 529 plan in that state to qualify for any tax incentive. However, in the following states you can claim 529 contributions to any plan:
In the majority of states offering 529 state tax benefits, your contributions to your 529 college savings plan are tax deductions. Tax deductions lower your taxable income, thereby reducing your tax burden.
The following states give tax credits for 529 account contributions:
- Minnesota (depending on income)
Tax credits reduce the amount of taxes owed. Say you would ordinarily owe $2000 in taxes and you receive a $500 tax credit – you then only owe $1500, since the $500 tax credit was subtracted from your tax bill.
Taking Indiana’s 529 plan as an example, if you contribute $5000 to their state-sponsored 529 account, you get a $1000 tax credit. Your Indiana state income tax bill would be $1000 less because of your 529 contribution.
3. Educational expenses include a lot more than just tuition
Most people hear “educational expenses” and assume that means tuition. In fact, 529 funds can be used to cover more than just tuition. You can also cover room and board (this one is a biggie!), supplies, books, computer equipment, etc.
And as of the 2017 tax bill, secondary education costs are also eligible. Check the IRS guide for full details here.
4. Easily change beneficiaries on your 529 plan
A great feature of a 529 account is how easy you can change beneficiaries. This means if your child decides not do further education or receives scholarships to cover her education costs, you don’t lose out on the tax advantages you built up.
You can change the beneficiary of your 529 account twice a year to another eligible family member (more on that below).
I took advantage of this feature to start saving for our kid’s future educational expenses before I was even pregnant. To open the account, I listed myself as both the account owner and beneficiary. Then when our baby got his own social security number, I submitted a quick form to change the beneficiary over to him (I remain the account owner).
This easy beneficiary change is also great if you have leftover funds after your child finishes their schooling. In the future, if our 529 account has remaining funds, I can change the beneficiary to other children or even future grandchildren, nieces or nephews, siblings, etc.
I could also change the account beneficiary back to myself. Some people take advantage of personal 529 accounts to go back to school later in life and cover some of their housing expenses through the ‘room and board’ educational expense category.
5. Many family members are eligible to be 529 savings plan beneficiaries
If you do want to change your 529 educational savings plan beneficiary, the list of eligible family members is long. This provides you a lot of flexibility in maximizing the benefit of your account.
Possible eligible family members for 529 plan beneficiaries include:
- descendants of a child (i.e. grandkids)
- first cousins
Family members include step-family members, adoptions, and fostering. The IRS guide that lists eligible family members is available here.
6. No deadline to use 529 account funds
There is no deadline on when 529 saving account funds have to be spent. If your kid does not use all the funds, they can be saved for future generations.
7. High annual contribution limits to 529 college savings plans
You are able to save a lot each year in your 529 college savings plan if you wish. Each parent may give up to $15000 each year to a 529 account before having to pay the gift tax (based on the 2020 gift tax exclusion limit).
529 savings plans also offer the opportunity to “superfund” your 529 account. Individuals may front load their 529 contributions by contributing up to $75000 in one year. This superfund amount is then treated it as if you gave it over up to a 5-year period, thus not triggering gift taxation. One may wish to superfund their 529 savings to give the funds more time in the market to grow.
Disadvantages of a 529 Education Savings Plan
While there are many pros to 529 accounts, there are some cons as well to which families need to be aware. Make sure to think about the following 529 plan cons before opening your college savings plan.
1. Inherent risk to investing, including 529 plans
As with any market-based investment, there is inherent risk when investing your educational savings in a 529 account. Since most children go to postsecondary education at about age 18, there is less time to wait out market down turns than you might have with your retirement accounts.
Most plans offer different investment options to match your personal risk tolerance. Many 529 funds also have age-based plans that will shift your portfolio to less risky holding as your child gets closer to college age to try to hedge risk.
2. Penalties if 529 savings are not used for education
Once your money is invested in a 529 account, any gains you withdrawal that are not used for qualified educational expenses will incur penalty fees, in addition to taxes owed. Currently, it is a 10% penalty in addition to the owed taxes for any funds not used for educational purposes.
3. You may be limited to state-sponsored plans to take advantage of state income tax benefits
To take advantage of your state’s income tax incentives, you likely have to use their state-sponsored plans. This means you have less flexibility in deciding where you want to open your account. Flexibility is important to avoid high account fees.
For example, right now I am not able to claim state tax deductions for my 529 account because it is run through a different state than my state of residence. I haven’t switched yet because my state’s plan limits me to only one investment management company with higher fees than I’d like.
4. 529 savings may impact future financial aid eligibility
529 savings accounts can impact a child’s financial aid eligibility.
I won’t get into the weeds on this in this post since how a possibly 529 impacts financial aid because it is very individual-specific, and depends on who owns the account and how the funds are liquidated and used.
For example, if the parent is the owner of the 529 account, it is reported on the FAFSA (Free Application for Federal Student Aid) as a parental asset. Parental assets are only part of the calculation for aid eligibility though. For a lot of families, the tax benefits of a 529 account outweigh the possible FAFSA ding.
A good overview on how 529 savings are taken into account when applying for financial aid is available here.
5. 529 account contributions may face gift taxation
529 contributions are subject to annual gift and generational-skipping transfer taxes. You can find more about IRS gift regulations here.
Currently the annual exclusion amount before triggering the gift tax is $15000 per person per year. As mentioned above, with 529 accounts you can superfund your contributions in one year up to $75000 and it is treated as if it was gifted over 5-year (thus not triggering gift taxation).
Generational-skipping transfer taxation occurs when an an older relative “skips” the middle generation and gives a very large sum directly to the younger generation (e.g. a grandparent to a grandchild, skipping the child’s parent). Generational-skipping transfers are taxed when the gifted or inherited amount is in excess of $11.5 million, so this will not impact most families.
6. Some 529 plans have high fees
The fees associated with 529 accounts vary greatly across plan providers. If you live in a state that requires use of their state-sponsored plans for state tax benefits, you may be limited to higher-fee plans.
If you are not limited in your 529 plan selection, Vanguard is generally considered to be the low-fee option for much of the investing world. Their age-based 529 portfolios currently have an expense ratio of 0.15%, compared to the industry average of 0.40%.
7. Most plans don’t offer an easy way for others to gift to your child’s 529 savings account.
Given today’s technology, you would think it would be as easy as sharing a link with loved ones that want to gift to education savings on holidays or birthdays. However, many 529 service providers don’t yet offer an easy way to share your child’s 529 account with friends and family wishing to contribute.
Personally, I was hoping for this feature to use in lieu of a baby registry. Unfortunately, our 529 account only accepts outside contributions through check or a wire transfer (which feels pretty antiquated if you ask me!). Hopefully this feature becomes more universal soon.
8. You have to keep records of your educational spending
Once you start spending your 529 distributions, you will need to start keeping records of your educational expenses. Your educational costs should match or exceed your 529 distributions in order to avoid penalty and taxes.
While you don’t have to report each educational transaction, you will want to maintain receipts and records as you would any other part of your taxes in case of a future audit.
9. 529 savings may impact other educational tax credits
You are not able to “double-dip” tax benefits for the same educational expense in the same year. If you pay for an educational cost with 529 distributions, you can’t claim that same educational expense for an educational tax credit, like the American Opportunity tax credit.
That said, you are able to use both 529 funds and an educational tax credit in the same year as long as you have educational expenses not paid for with 529 distributions. For example, if you only pay for half of your child’s tuition with 529 savings, you may be able to claim the other half of the tuition for educational tax credits.
After weighing the pros and cons, I decided to open a 529 college savings plan for our baby. I set up monthly contributions to to put our education savings on autopilot.
Have you opened a 529 account? What advantages or disadvantages swayed your decision? Let me know in the comments.
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