Investing In A 529 Plan: A Smart Move?

A 529 plan is a tax-advantaged savings plan designed to help pay for education. It is named after Section 529 of the Internal Revenue Code (IRC) and offers tax-free investment growth and withdrawals for qualified education expenses. While originally intended for post-secondary education, recent changes now allow 529 plans to be used for K–12 education costs, apprenticeship programs, and student loan payments. Anyone can open a 529 account, but they are typically established by parents or grandparents for a child or grandchild, and offer high contribution limits. So, does it make sense to invest in a 529 plan? Let's take a look at some of the pros and cons.

Tax advantages and disadvantages

Named after Section 529 of the Internal Revenue Code (IRC), 529 plans are tax-advantaged accounts that can be used to pay for educational expenses, including K–12 education, apprenticeship programs, and student loan repayment. They are designed to encourage savings for the cost of college education, with contributions made using after-tax dollars, tax-free investment growth, and tax-free withdrawals for qualified expenses.

Advantages

• Tax-deferred growth: Contributions grow free of federal and state income taxes while in the account.
• Tax-free withdrawals: No income tax is paid on the growth of the account when withdrawals are used for qualified expenses.
• State tax deduction: Many states offer tax deductions or credits for contributions, which can be a significant benefit for residents of those states.
• Estate planning and accelerated gifting: 529 plans allow for accelerated gifting, reducing the taxable estate. This means contributing up to five years' worth of gifts in a single year without triggering gift taxes.

Disadvantages

• Limited investment options: 529 plans are administered by each state, and the investment options may be limited or include high-cost funds.
• Strict rules: 529 plans have strict rules, and withdrawals must be used for qualified educational expenses. Non-qualified withdrawals are subject to taxes and a 10% penalty.
• Impact on financial aid: Assets in a 529 plan may reduce the amount of financial aid a student is eligible for. Parent-owned 529s have a smaller impact than student-owned accounts.
• High contributions and fees: Some state plans require high minimum contributions and may have relatively high fees, which can eat into investment returns.

Investment choices

A 529 plan may allow you to invest in a number of different assets, including stock funds, bond funds, and FDIC-protected money market accounts. Many states also offer target-date funds that adjust the mix of your investments so they become less risky as you approach the time to use the money.

However, 529 plans are administered by each individual state, and the plans may not offer an attractive investment opportunity, depending on which plan you choose. For example, some state plans may offer only high-cost funds or a limited selection of funds. For those with investment expertise, this can be a significant downside compared to investing money in more attractive things such as individual stocks.

If you are less confident in your investment expertise, the limited options may be acceptable and even preferable. The Vanguard 529 Plan, for example, has options for both hands-on investors who want to strategize and choose their own asset mix, and those who would rather not manage their investments and instead opt for a Target Enrollment Portfolio, which automatically adjusts to become more conservative as the beneficiary approaches their enrollment date.

When choosing a 529 plan, it is important to research the different investment options available to you and decide which best aligns with your goals and risk tolerance.

Plan differences

There are two main types of 529 plans: college savings plans and prepaid tuition plans. Here are the key differences between the two:

College Savings Plans

College savings plans are the most common type of 529 plan and are generally considered the most flexible option. They offer tax-deferred growth, meaning investments grow tax-free. Withdrawals are also tax-free when used for qualified education expenses. These plans remain under the control of the donor, usually a parent. There are no annual contribution limits, but there are limits on the total amount that can be contributed over time, ranging from $235,000 to $575,000. Many 529 plans offer target-date funds, which adjust their assets over time to become more conservative as the beneficiary approaches college age.

Prepaid Tuition Plans

Prepaid tuition plans are offered by some states and higher education institutions. They allow account owners to lock in current tuition rates for future attendance at selected colleges and universities, which can result in lower prices for college later on due to the rising costs of tuition. Prepaid tuition plans are not available for K–12 education. While withdrawals from these plans used to pay tuition are not taxable, they do not cover room and board costs. Prepaid tuition plans may also place restrictions on which colleges they can be used for.

Penalty triggers

• The most important rule to avoid penalties is to use the funds in a 529 account for qualified educational expenses. These typically include tuition and fees, room and board, textbooks, computers, and other equipment or software needed for school. They may also include K-12 tuition at private schools and qualified apprenticeship programs.
• If you withdraw funds from a 529 plan for non-qualified expenses, you will likely incur a penalty. This penalty includes a 10% tax on the investment gains, in addition to regular taxes. So, it's important to be clear about what qualifies as an educational expense to avoid this penalty.
• For example, college application fees, travel costs to and from campus, and extracurricular activities are generally not considered qualified expenses and could trigger a penalty if paid for with 529 funds.
• The rules for 529 plans can be strict, and it's possible to accidentally trigger a penalty. For instance, withdrawing a full year's tuition at the start of the school year when only one semester's tuition is due could result in a penalty, even if you intend to use the funds for qualified expenses later.
• In some cases, there are exceptions to the 10% penalty. These include the death or disability of the beneficiary, receiving a tax-free scholarship, or attending a U.S. Military Academy.
• It's worth noting that contributions to a 529 plan itself are not subject to penalties. Only the earnings within the plan will be penalized if withdrawn for non-qualified expenses.
• Additionally, there may be state-specific rules and penalties for 529 plans, so it's important to review the details of your state's plan.

Federal aid impact

When it comes to federal aid, the impact of a 529 plan depends on who owns the account. If the plan is owned by the beneficiary's parent, 5.64% of the account's value is considered in the Student Aid Index (SAI) calculation, which determines a student's financial aid eligibility on the Free Application for Federal Student Aid (FAFSA). This means that parental assets, such as a brokerage account, savings account, or other assets, will reduce a student's aid package by up to a maximum of 5.64% of the asset's value. For example, if a parent-owned 529 savings account contains $10,000, the child's financial aid award could be reduced by up to $564.

On the other hand, if the plan is owned by the student, up to 20% of the account value may be considered in calculating financial aid eligibility. In this case, a $10,000 student asset could result in a reduction of $2,000 in financial aid.

It is important to note that assets in a 529 plan owned by a grandparent or other relative are not included in the FAFSA calculation. Additionally, in cases of divorce, only the parent who provides greater financial support to the student needs to file the FAFSA, and if the other parent owns a 529 plan, it is not reported.

The impact of 529 assets on financial aid also depends on the type of aid being applied for. While 529 assets are considered in FAFSA calculations, fewer than 200 colleges use the College Scholarship Service (CSS) Profile, which takes into account grandparent-owned 529 plans.

Overall, while 529 plans can have an impact on federal aid eligibility, the effect is relatively small compared to income. It is also important to consider the benefits of a 529 plan, such as tax advantages and the ability to save for future education expenses, when making a decision about whether to invest in one.

Frequently asked questions