The decision to save for your children’s education is a personal one. If you are in the position to make this financial decision, you are likely doing well. For today, we are going to assume that you clicked on this blog post because you are considering different options to invest in your children’s education. The purpose of this article isn’t to give investing advice, though we will attempt to answer the question, “Is a 529 plan worth it”?
There are a number of different ways that you can save for your children’s college education. You can do it the old fashioned way and open a bank account designed for college savings. Or you can have them contribute to a Roth IRA that can be used for college expenses when your kids get a little older and have some earned income. Finally, there are other less commonly discussed options such as custodial accounts, life insurance policies, and tax-deferred trust accounts.
When our children were born a few years ago (they are now 7 and 3), we decided to open up 529 accounts for each of them. After considering all of the options, we felt it was the best option for our family. There is one particular reason that really stood out to us that we’ll cover later in the article. It’s a reason that on the surface may not be apparent, but to us it has been the best part of having 529 plans for our children.
What is a 529 Plan?
Before we get too far, let’s pause for a second and share more about 529 plans. Why were these random numbers chosen for this college savings option?
Like many other random strings of numbers that represent some type of investment account (see 401k), it represents a section in the Internal Revenue Service (IRS) tax code. Super exciting, I know.
A 529 plan is an investment account that offers tax-free earnings growth and tax-free withdrawals when the funds are used to pay for qualified educational expenses. This generally applies to college expenses such as tuition, books, and other fees, though can also be used for K-12 school tuition.
529 plans are sponsored by state or state agencies. Nearly all 50 US states offer 529 plans. While it’s great to have options, it’s also a bit confusing because there are slight differences between states in the way 529 accounts are treated. For example, some states allow for you to take a tax deduction (state only, not federal deduction). Also, the investment options tend to be different between different states. Regardless, the overall premise is the same. 529 plans provide parents with the option of saving for their children’s future education needs.
What Makes a 529 Plan Worth It?
The reasons below are what makes a 529 plan worth it to us. There are some people that are scared of putting money into a college savings account. If your child doesn’t go to college or receives a scholarship, then what happens? We’ll get to those questions later in the article. For now, here are a few reasons why we chose to open 529 plans for our kids.
Ability to Receive Gifts
Have you ever been in a situation where you wanted to give a niece, nephew, or other child money for their college education? How would you feel about just handing the parent $50 for some future college expense? I don’t know about you, but no matter my relationship with that family member or friend I’d be a little hesitant to just hand over money. In my experience, other adults feel the same way.
Most 529 accounts provide a simple way for family or friends to donate. The video below from my state’s 529 provider shows the simple process to request gifts. While the process for other states may differ, most have some type of process to request a gift.
The ability to provide family or friends the assurance that their generous gift will go into an account specifically for college education is the biggest benefit of a 529 in my opinion. It shows that you are serious about saving for your child’s education. It also reassures that you aren’t planning to take that money and spend it on something different.
Automatic Contributions and Investments
Most 529 plans also allow for direct deposit payroll deductions from your employer. We personally put $50 every paycheck into each of our kids’ college fund. While this doesn’t seem like much and likely won’t cover their college expenses, even these small contributions can add up to big dollars over time.
Similar to other investment accounts, putting your money into a 529 is the first step. You’ll also want to ensure that your money is invested. What does this mean? Generally, you’ll have options to invest your 529 contributions into an index or mutual fund. You’ll have multiple options, some more aggressive (higher potential return, but more risk) and others more conservative (lower potential return, but less risk). Our 529 in Missouri provides three investment options in Vanguard funds. We currently invest in more aggressive funds as our kids are still younger (7 and 3) but will likely move to a more conservative option as they get closer to college.
You’ll want to spend some time comparing different 529 plans to see which is best for your family. Different 529 plans offer different investment options, some with lower fees than others. Even if you are from Missouri, like our family, you have the option to invest in 529 plans in other states.
States Offer Tax Deductions or Credits
The following states allow for 529 plan state tax deductions: Arizona, Arkansas, Kansas, Minnesota, Missouri (woohoo!), Montana, and Pennsylvania. Some states (Pennsylvania and Montana) allow for a state tax deduction regardless of the state you are from, though there may be limitations on the amount. Other states, such as Indiana, Minnesota, Utah, and Vermont offer tax credits. Please note that there is not a tax deduction available at the federal level.
The nuances between the tax benefits of 529 plans can get complicated. Be sure to have a conversation with an accredited financial advisor or do your own research to find out which will provide the most benefit to you. There are several factors to consider, such as the tax benefits and investment option fees. At the same time, don’t let complexity be the enemy of taking action.
Tax-Free Growth on Investment Earnings
When you put your money into a 529 account you can rest assured that money will not be taxed when you withdraw for qualified education-related expenses. This is a significant benefit as the growth on earnings can add by the time you’re ready to ship your kid off to college.
For example, let’s say you contribute $1,000 per year into your child’s 529 account for a total amount of $18,000 over 18 years. If you get a 7% return on your investments, you’ll end up with roughly $34,000, which includes your contributions of $18,000 plus $16,000 from interest from investing.
If you simply put that money into a brokerage account (such as Vanguard or Fidelity) and achieve the same rate of return, you’ll need to pay taxes on the $16,000 you earned in interest. Depending on a variety of factors, this could account for 15-20% in capital gains tax. Therefore, in this example, you’d potentially have to pay $2,400-$3,200 in taxes upon withdrawal. This alone makes a 529 account well worth it.
What If My Child Doesn’t Go To College or Gets a Scholarship?
Two of the most frequently asked questions about 529 accounts are, “what if my child doesn’t go to college?” and “what if my child gets a full scholarship?” These are both legitimate questions. It’s difficult to know exactly what college will look like 18 years after the birth of your child. Also, as much as we want to believe that our kids will choose to go to college, that may not always happen. Some may enter into a trade, start a business, or go another non-traditional route.
The good news is that if your kid doesn’t go to college you’re not going to lose any money that you’ve already contributed. From our example above, you can remove the $18,000 you’ve contributed without any type of penalty.
Now the $16,000 in interest accumulated is a bit more complicated. If you choose to use the money for non-qualified expenses you’ll end up having to pay taxes plus a 10% penalty. However, if your child ends up getting a full scholarship, you can likely avoid the 10% penalty. Therefore, it wouldn’t end up being much different than investing that money into a brokerage account.
In general, there are a number of options if your child ends up not going to college or ends up with a scholarship. You can easily transfer money between children, you can use the money for private K-12 tuition and other certifications, and you can even use the money for your own education expenses. So while there is some risk in getting hit with a 10% penalty, that is a worst case situation that doesn’t come to fruition all that often given other potential options.
So, Is a 529 Plan Worth It?
After considering the alternatives, our family has decided that a 529 plan is worth it. We’ve covered several of the benefits, though the two that rose to the top for us include tax-free growth on investments for qualified educational expenses and the ability to easily provide gifting options to family and friends. Personally, we would think twice about handing money over for future educational expenses not knowing exactly what parents plan to do with it.
Having a 529 account sends a message that you are serious about saving for college, and that the money gifted will go into an account specifically designed for future educational expenses. That, in itself, is worth it to us. So instead of asking for toys that will only be played with a few times before finding the storage closet, set yourself up to receive contributions that can compound into paying for a college education. Of course, you can also make your own contributions.