Is a 529 Plan The Best Way to Save For College?

Q: I have a four-year-old. Is a 529 plan the best way to save for her college education?

A: For most people, a 529 plan is the logical starting point for their college savings because earnings in the 529 plan are Federal (and sometimes state) income tax-free if spent on qualified educational expenses at a qualifying educational institution. But for most people the 529 should not be the only funding vehicle, and it can pay to seek some objective, expert advice before proceeding.

What is a 529 plan, anyway?

In brief, a 529 plan can be an attractive college savings vehicle because investment earnings in the plan are tax-free if spent on tuition, fees, books, supplies, equipment (including computers), and room and board, at a qualifying educational institution, for a qualifying beneficiary. This can get technical, but in our brief space here, suffice it to say that the balance in the 529 can be used to pay most college expenses. The term “qualifying educational institution” is very broad, too, and includes almost all colleges (including some colleges in other countries, some trade schools and even a couple of golf schools).

The best thing about a 529 plan is that it enables you to set aside money for a child’s college without losing control of the money. By way of contrast, many people use an UTMA (Uniform Transfer to Minors Act) trust to provide a segregated account for a child’s college expenses, but the balance in an UTMA becomes the unrestricted property of the child at majority (age 21 in Texas). Thus, if the child decides not to go to Harvard and spends her UTMA on a Harley instead, there is nothing to be done about it. In contrast, you control expenditures from the 529 plan, so you can be sure that the balance will be used only as you intended.

By the by, you get a tax deduction for money you contribute to a 529 plan.

What’s the catch?

The biggest catch is that, if the money in the 529 plan is withdrawn but not spent on educational expenses – for example, if you withdraw the balance to fund your retirement – investment earnings in the plan are subject to ordinary income tax plus a 10% penalty. So if your child doesn’t attend college – or selects a lower-cost institution than originally planned – you may have a significant amount of money stranded in her 529 plan. For this reason, I typically recommend saving no more than about 60% of anticipated college expenses in a 529. Yes, it may be possible to designate a different beneficiary but this may or may not work as you’d hoped for either. As any parent knows, including this one, our offspring don’t always perform exactly as predicted!

Where to save the remaining 40% of your anticipated college expenses? You can establish a separate taxable investment account for the college savings, or you can simply blend it in with the rest of your taxable savings and do some mental accounting to track it.

Additional angles

If you establish a 529 plan for a child and she doesn’t go to college, all may not be lost; you can shift the 529 plan to a sibling. Or, you may leave the balance alone, let it grow, and hope that eventually a grandchild can use it for college expenses.

Grandparents’ note: You designate a beneficiary when you establish the 529 plan. People usually designate their children, but the beneficiary can be anyone. Thus a 529 plan offers a great way for a grandparent to give to their grandchildren (and the balance of a 529 plan owned by a grandparent generally will not count against the child for purposes of colleges’ financial aid calculations, so generally the existence of the plan won’t reduce financial aid, as it will if it’s owned by the child or the parent). A 529 plan can even be a way for you to save for yourself, if you’re planning to return to college. Keep in mind, though, that the beneficiary can only be changed to another family member of the original beneficiary. So if you establish a 529 plan for a friend’s child, you can’t change the beneficiary to your own child.

Another tip: Some states offer a state income tax break for contributions to their 529 plans. (Because Texas doesn’t have an income tax, Texas doesn’t offer an income tax break for contributions to college savings plans.)

An additional caution

Many people assume that the federal income tax break makes every 529 plan a good deal. Not so. Remember if you buy a 529 plan from a broker, a commission will be involved, reducing the benefit of the plan to the beneficiary. And as with 401(k) plans, there are management fees and plan expenses built into 529 plans. These costs are not always so obvious, and sometimes they are destructively burdensome. Say you’re paying 2% to 3% per year among commissions, the program fee and fund fees. You have to overcome all these expenses before you even begin to break even – and a positive return is not guaranteed with any investment. Some 529 plans’ expenses may result in higher hurdles than if you simply invested the same amounts in a taxable account. You can compare costs at www.savingforcollege.com

Remember, too, that a 529 plan might not be your only college savings option. In Texas, for example, the prepaid tuition plan is worth considering. With it, you buy a block of college time for future use, locked in at today’s prices. An exploration of prepaid tuition plans warrants a separate article, but suffice to repeat that families planning for college have a number of options to consider.

A final caution: This is only the tip of the informational iceberg on 529 plans. The details are complicated. Professional advice from a fee-only financial advisor is a good idea. Call if we can help.

About the author

Tom Posey, CFP®, J.D., AAMS

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