The decision to save for your children’s education is a personal one. If you can make this financial decision, you are likely doing well. Today, we assume 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 several different ways to save for your children’s college education. You can do it old-fashioned 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, other less commonly discussed options include custodial accounts, life insurance policies, and tax-deferred trust accounts.
When our children were born a few years ago (now 9 and 5), we decided to open up 529 accounts. After considering all the options, we felt it was the best option for our family. However, one particular reason 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 and share more about 529 plans. Why were these random numbers chosen for this college savings option?
Like many other random strings of numbers representing some investment account (see 401k), it means 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. Qualified expenses generally apply to college expenses such as tuition, books, and other fees, though we can also use them for K-12 school tuition.
State or state agencies sponsor 529 plans, with nearly all 50 US states offering 529 programs. While it’s great to have options, it’s also confusing because states differ slightly regarding how 529 accounts are treated. For example, some states allow you to take a tax deduction (state only, not federal). Also, the investment options tend to be different between different states. Regardless, the overall premise is the same. 529 plans allow parents to save for their children’s future education needs.
What Makes a 529 Plan Worth It?
The reasons below are what make a 529 plan worth it to us. Some people are scared of putting money into a college savings account. What happens if your child doesn’t attend college or receive a scholarship? We’ll get to those questions later in the article. 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 handing the parent $50 for some future college expenses? I don’t know about you, but I’d hesitate to hand over money, no matter my relationship with that family member or friend. In my experience, other adults feel the same way.
Most 529 accounts provide a simple way for family or friends to donate. For example, the video below from my state’s 529 provider shows the simple process of requesting gifts. While the process for other states may differ, most have some method to request a donation.
In my opinion, the ability to provide family or friends the assurance that their generous gift will go into an account specifically for a college education is the most significant benefit of a 529. It shows that you are serious about saving for your child’s education. It also reassures that you aren’t planning to spend that money on something different.
Automatic Contributions and Investments
Most 529 plans also allow for direct deposit payroll deductions from your employer. As a result, we put $50 every paycheck into each of our kids’ college funds. 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.
Putting your money into a 529 is the first step, like other investment accounts. 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 possible return, but less risk). For example, our 529 in Missouri provides three investment options in Vanguard funds. We currently invest in more aggressive funds as our kids are still younger, but we will likely move to a more conservative option as they get closer to college.
You’ll want to compare 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 can 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 no tax deduction available at the federal level.
The nuances between the tax benefits of 529 plans can get complicated. Be sure to talk with an accredited financial advisor or do your research to find out which will benefit you most—several factors to consider, such as the tax benefits and investment options 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. Tax-free growth is a significant benefit as the growth in earnings can add up by the time you’re ready to ship your kid off to college.
For example, you contribute $1,000 yearly to your child’s 529 accounts for $18,000 over 18 years. If you get a 7% return on your investments, you’ll end up with roughly $34,000, including your contributions of $18,000 plus $16,000 from interest from investing.
If you 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. This could account for 15-20% of capital gains tax depending on various factors. Therefore, you’d have to pay $2,400-$3,200 in taxes upon withdrawal in this example. The tax savings alone make 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 isn’t easy to know what college will look like 18 years after your child’s birth. Also, as much as we want to believe that our kids will choose to attend college, that may not always happen. Some may enter 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 losing any money you’ve already contributed. So you can remove the $18,000 you’ve contributed without penalty from our example above.
Now the $16,000 in interest accumulated is a bit more complicated. You must pay taxes plus a 10% penalty if you use the money for non-qualified expenses. However, you can likely avoid the 10% penalty if your child gets a full scholarship. Therefore, investing that money into a brokerage account wouldn’t be different. Also, starting in 2024, options will be available to roll unused 529 dollars into a Roth IRA.
There are several options if your child does not attend college or ends up with a scholarship. For example, you can quickly transfer money between children, use the funds for private K-12 tuition and other certifications, and even use the funds for your 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 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 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 provide gifting options to family and friends quickly. We would think twice about handing money over for future educational expenses, not knowing what parents plan to do.
A 529 account sends a message that you are serious about saving for college and that the money gifted will go into a version specifically designed for future educational expenses. That, in itself, is worth it to us. So instead of asking for toys that your kids will only play 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 contributions.
Mark is the founder of Financial Pilgrimage, a blog dedicated to helping young families pay down debt and live financially free. Mark has a Bachelor’s degree in financial management and a Master’s degree in economics and finance. He is a husband of one and father of two and calls St. Louis, MO, home. He also loves playing in old man baseball leagues, working out, and being anywhere near the water. Mark has been featured in Yahoo! Finance, NerdWallet, and the Plutus Awards Showcase.