Invest 529 Funds: Strategies For Maximizing College Savings

A 529 plan is a tax-advantaged savings plan designed to help pay for college expenses. It is named after Section 529 of the Internal Revenue Code (IRC) and offers tax-deferred growth, with withdrawals exempt from federal and state income taxes when used for qualified educational expenses. With the average cost of a four-year college education ranging from $100,000 to over $200,000, 529 plans are an attractive option for parents looking to secure their children's academic future. In this article, we will discuss how to invest in a 529 plan, the different types of plans available, and the key considerations for parents or guardians.

Choosing between a savings plan and a prepaid plan

When it comes to saving for college, there are two types of 529 plans to choose from: a savings plan or a prepaid plan. So, how do you decide between the two? Here are some key things to consider:

Flexibility

One of the most significant differences between the two plans is the flexibility they offer in terms of how the funds can be used. A 529 savings plan can be used to pay for a wide range of expenses, including tuition, books, equipment, fees, room and board, at a variety of qualifying institutions, such as private or public colleges, graduate and professional schools, technical and trade schools, and even foreign universities. On the other hand, a prepaid plan typically only covers tuition at in-state public colleges, and may have restrictions if the student moves to another state or loses their resident status. Additionally, 529 savings plans generally offer more flexibility regarding beneficiaries, allowing transfers to anyone of any age within the original beneficiary's family.

Account Growth and Risk

Prepaid plans offer the advantage of locking in current tuition rates, shielding parents from investment risk as returns are consistently positive. However, these plans generate very little growth, which can be a problem if the child does not use the tuition credits. In contrast, a 529 savings plan offers the potential for higher returns, but with higher risk. A 529 plan that is heavily weighted in stock investments may have much higher earning potential but is subject to market volatility.

Enrollment

With a 529 savings plan, parents can start investing at any time. In contrast, enrollment periods for prepaid plans are much more restrictive and typically only open for a few months each year. Additionally, the age of the student can affect enrollment, with some plans not allowing students in the ninth grade or older to enroll in a prepaid plan.

Investment Management

With a 529 savings plan, you have the option to choose from several investment options and change the investment allocations yourself. In contrast, with a prepaid plan, the state does the investing for you, so there is nothing for you to manage.

Tax Benefits

Both 529 savings plans and prepaid plans offer tax advantages when the funds are used for qualified educational expenses. Earnings are typically tax-free, and some states may offer additional tax deductions or credits for contributions. However, it's important to note that the tax benefits may vary from state to state, so be sure to check the details of the plan in your state.

Refund Options

If your child decides not to go to college, both plans offer refund options. With a 529 savings plan, you can transfer the funds to another qualifying family member or withdraw the remaining balance (taxes and penalties may apply). With a prepaid plan, you can generally transfer the plan to another family member or get a refund for what you paid.

In conclusion, both 529 savings plans and prepaid plans have their advantages and disadvantages. When deciding between the two, it's important to consider your child's goals, your financial situation, and the level of flexibility and risk you are comfortable with.

Selecting an investment portfolio

When you enrol in a 529 college savings plan, you will need to select an investment portfolio from the options offered by your plan. Here are some factors to consider when selecting an investment portfolio:

• Age-based and enrolment date portfolios: These portfolios are best for savers who prefer a "set it and forget it" approach. The portfolio's asset allocation will automatically adjust over the plan's life based on the child's age or time until expected college enrolment. In the early years, the portfolio typically has a higher allocation of stocks, which have higher risk but also the potential for higher returns. As the child gets closer to college, these portfolios shift towards more conservative investments, such as bonds or money market funds, to protect against volatility and market downturns when college expenses are imminent.
• Static portfolios: The portfolio's asset allocation remains focused on achieving a specific investment objective unless the plan owner manually reallocates to other portfolios. This option is best for more experienced investors. Static portfolios include target-risk portfolios, which focus on a defined risk or investment strategy level, and individual portfolios, which mirror an underlying mutual fund, exchange-traded fund, or other investment.
• Risk tolerance: It is important to understand the level of risk a portfolio will take on (conservative, moderate, or aggressive) and match it against your risk tolerance and objectives. Age-based portfolios, for example, can vary greatly in terms of the level of risk involved.
• Investment type: Pay attention to the costs associated with different investment types. Fees and expenses can eat away at your investment returns and shrink your education savings. Many 529 plans have been reducing their fees, and there are now many low-cost options available. Compare fees before deciding which 529 plan and investment portfolio to choose.
• Investment strategies: Depending on your overall investment and portfolio strategy, you can choose between a static or age-based strategy when structuring your 529 plan's investments. With a static portfolio, you have more control over the allocation of equity and fixed-income percentages, whereas age-based portfolios are set up to reallocate over time and become more conservative as college enrolment approaches.

Understanding the tax advantages

529 plans are named after Section 529 of the Internal Revenue Code (IRC) and are tax-advantaged accounts designed to help pay for educational expenses. They are sponsored and run by the 50 states and the District of Columbia, and their rules and fees differ from state to state.

Tax-Deferred Growth

Contributions to 529 plans grow free of federal and state income taxes while in the account. This means that the money in a 529 plan grows tax-deferred until it is withdrawn. As long as the funds are used for qualified education expenses as defined by the Internal Revenue Service (IRS), withdrawals are exempt from federal and state income taxes.

Tax-Free Withdrawals

Withdrawals from a 529 plan are not subject to income tax when used for qualified expenses. This includes tuition, fees, room and board, and related costs for college and K-12 education. In addition, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 expanded tax-free withdrawals to include registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for account beneficiaries and their siblings.

State Tax Deduction

Many states offer tax deductions or credits for contributions to 529 plans. For example, in New York, residents can receive an annual state income tax deduction for 529 plan contributions of up to $5,000 ($10,000 if married and filing jointly). However, to be eligible for a state tax deduction or credit, you typically need to invest in your home state's plan.

Estate Planning & Accelerated Gifting

529 plans offer unique estate planning and accelerated gifting benefits. You can contribute up to five years' worth of annual gift tax exclusions in a single lump sum without triggering gift tax consequences. For example, in 2024, a grandparent could contribute $90,000 to their grandchild's 529 plan ($18,000 annual exclusion x five years) without it counting against their lifetime gift tax exemption.

Rollover to Roth IRA

The SECURE 2.0 Act of 2022 allows for the rollover of up to $35,000 of unspent funds in a 529 account into a Roth IRA, provided the account is at least 15 years old.

Knowing what a 529 plan can and can't be used for

A 529 plan is a powerful tool that parents and family members can use to save for a child's education. It offers tax advantages when the money in the account is used for qualified education expenses. However, there are rules and restrictions on what 529 funds can be used for.

What a 529 Plan Can Be Used For

529 plans can be used to pay for qualified education expenses, which include:

• Tuition and fees for college, vocational school, or K-12 schools (up to $10,000 per year for K-12)
• Books and supplies required for classes
• Computers, software, and internet access (if the beneficiary is enrolled at least half-time)
• Room and board expenses, both on and off-campus (up to the cost of on-campus room and board)
• Special needs equipment and services for students with disabilities
• Student loan repayments (up to a lifetime limit of $10,000)
• Transfer of leftover funds to a beneficiary's Roth IRA (up to $35,000)

What a 529 Plan Cannot Be Used For

529 plans cannot be used for non-qualified expenses, which include:

• Transportation and travel costs, such as airfare, gas, or vehicle maintenance
• Health insurance, unless it is charged as part of a comprehensive tuition fee or required for enrollment
• College application and testing fees, as these are incurred before admission to a college or university
• Non-required books and supplies, such as extra reading materials or hobby-related software
• Prepaid tuition plans, such as the Private College 529 Plan, cannot be used for room and board expenses

Adding a 529 plan to your existing investment strategy

Understanding 529 Plans

529 plans are tax-advantaged savings plans named after Section 529 of the Internal Revenue Code (IRC). They are designed to help pay for college expenses, and in some cases, K-12 education, apprenticeship programs, and student loan repayment. 529 plans are sponsored and run by states and the District of Columbia, and anyone can open an account. However, they are typically established by parents or grandparents for a child or grandchild, the account's beneficiary.

Types of 529 Plans

There are two main types of 529 plans:

• Education Savings Plans: These plans offer tax-deferred growth, and withdrawals are tax-free when used for qualified education expenses. Account holders contribute money, which is invested in a preset selection of investment options, usually mutual funds. Many 529 savings plans offer target-date funds that adjust their assets as the beneficiary approaches college age.
• Prepaid Tuition Plans: These plans allow account owners to lock in current tuition rates for future attendance at selected colleges and universities. Prepaid plans are not available for K-12 education and do not cover room and board costs.

Factors to Consider

When adding a 529 plan to your investment strategy, consider the following:

• Tax Benefits: Withdrawals from 529 plans are generally exempt from federal and state income taxes when used for qualified educational expenses. However, tax benefits can vary by state, so be sure to understand the specific benefits of your plan.
• Investment Options: 529 plans typically offer age-based and enrollment date portfolios, which automatically adjust their asset allocation based on the child's age or time until college enrollment. For more experienced investors, static portfolios are also available, which remain the same over the life of the plan unless manually reallocated.
• Fees and Expenses: Pay close attention to the fees associated with 529 plans, as they can vary by state and provider. These may include annual maintenance fees, asset management fees, and ongoing fees for individual investments.
• State-Specific Considerations: Each state's 529 plan has its own set of advantages, and some benefits may be limited to residents. Consider your state's plan first and weigh the potential tax benefits against the cost and quality of the plan.
• Timing: The earlier you start a 529 plan, the more time your savings will have to grow. However, don't be discouraged if you're starting later; you can still take advantage of the benefits of a 529 plan.

Frequently asked questions