Why a 529 Savings Plan is the Best Way to Save for College

Many parents utilize a 529 college savings plan to save for future college expenses because of the many benefits associated with these savings vehicles. From tax advantages, to flexibility of the plans and even the ability for anyone to invest on behalf of the child, 529 plans have become the number one choice in saving for college.

What is a 529 Plan?

A 529 savings plan offers tax advantages for parents who are saving for both college and/or K-12 tuition. 

Similar to a ROTH IRA, a 529 plan uses after-tax dollars for savings. The earnings inside the 529 plan then grow tax-free and withdrawals are not taxed if used for qualified college or K-12 expenses.

How Does a 529 Plan Work?

You may have been told in the past that 529 plans were only for higher education (college) expenses, and you were once right. However, with the passing of the Tax Cuts and Jobs Act, 529 plans can be used to pay for up to $10,000 worth of tuition per beneficiary each year at an elementary or secondary (k-12) public, private or religious school.

Every state and the District of Columbia has at least one state-sponsored 529 plan. For example, Idaho has just one 529 plan — The Idaho College Savings Plan (IDeal)

The state of Virginia has two 529 plans – a direct-sold 529 college savings program called Invest529 and an advisor-managed 529 plan called CollegeAmerica through American Funds. 

You can also invest in any state’s 529 plan you choose, however there may be increased tax advantages to saving inside your own state’s plan.

The Benefits of 529 Savings Plans

The amount saved into 529 plans has increased from $113 billion in 2009 to $352 billion in 2019. The reason for the increased popularity of college savings plans are the tax and financial benefits that go along with the flexibility of saving in them.

1. Tax-Free Earning and Withdrawals

Your 529 plan contributions do not qualify as a federal tax deduction but they may qualify for your state tax deduction. Most states will not give you the state tax-deduction unless you save inside your own state’s 529 plan. 

2. State Tax Deductions

Depending on the state you live in, you can get a state tax deduction on your after-tax dollars saved into a 529 plan. 

Most states require you to invest inside your own state’s 529 plan, however there are a few states that will give you the deduction no matter where you choose to save.

These seven states let you deduct 529 contributions even for out-of-state 529 plans:

• Arizona
• Kansas
• Minnesota
• Missouri
• Montana
• Pennsylvania
• Utah

For example, if you live in Arizona and you invest in Virginia’s 529 plan, you will still receive a Arizona state tax deduction for your contributions.

The following states only offer tax benefit if you invest into the state’s plan where you reside.

• Alabama
• Arkansas
• Colorado
• Connecticut
• Georgia
• Idaho
• Illinois
• Iowa
• Louisiana
• Maine
• Maryland
• Massachusetts
• Michigan
• Mississippi
• Nebraska
• New Hampshire
• New Mexico
• New York
• North Dakota
• Ohio
• Oklahoma
• Oregon
• Rhode Island
• South Carolina
• Vermont
• Virginia
• West Virginia
• Wisconsin

Now for example, if you live in Idaho and you invest in Utah’s my529 Plan, you will not receive a state deduction for contributions. 

Also, each state sets their own limits on deductions. For example, in Virginia both single and married filers can deduct up to $4,000/year per beneficiary if they invest into a Virginia 529 plan.

However, if you live in Arizona, you can deduct $2,000/year filing single or $4,000/year filing jointly and you can also invest in any state’s 529 plan.

3. Flexibility

Every 529 plan can have only one beneficiary. However, if the beneficiary no longer needs the funds from the 529 savings plan, you can change the beneficiary to any qualifying family member.

Qualifying family members are any of the following:

1. Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.
2. Brother, sister, stepbrother, or stepsister.
3. Father or mother or ancestor of either.
4. Stepfather or stepmother.
5. Son or daughter of a brother or sister.
6. Brother or sister of father or mother.
7. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
8. The spouse of any individual listed above.
9. First cousin.

This often happens if the beneficiary either decides they no longer want to attend college, they get a scholarship and no longer need the funds, or they only require a portion of the funds. 

Another perk with a 529 plan is you can take the unused portion after the beneficiary finishes college and can apply it to another child. For example, let’s say you have two children and they are 5 years apart. If the older beneficiary finishes college and has funds leftover, you can then change the beneficiary of that 529 plan to your younger child.

4. High Contribution Limits

529 plans themselves have very high contribution limits. The contribution limits are not annual limits, but instead are lifetime contribution limits that range anywhere from $235,000 to $500,000.

However, as the individual contributing to the 529 plan, you are limited to $15,000 per year, per child, or $30,000 per year, per child if married filing jointly. There are unique ways around this limit to increase this amount up to $150,000 and you should contact your tax professional to understand more.

5. Anyone Can Contribute to the 529 Plan

Usually the parent or grandparent will open the account and become the custodian for the beneficiary. However, anyone that wants to save money into the beneficiary’s 529 plan is allowed to and can also take advantage of the tax deduction.

For example, let’s say you open a 529 savings account for your newborn son. Not only can you save into the plan, but so can any other family member, friend, or anyone else who would like to.

CollegeBacker is one the most popular 529 savings platforms because they focus on this area of the 529 – making it simple for anyone to save into your child’s 529 plan using a simple link via text message or email.

The Downside to 529 Plans

Just like with any type of investment vehicle, there will be pros and cons. The pros of using a 529 plan are the tax advantages and the focused intent on saving for future college expenses. However, there are some disadvantages as well.

1. Ten Percent Penalty If Not Used Correctly

Just like any other tax advantage plan, if not used correctly, you’re going to pay the government a 10% penalty. If you don’t use the savings for qualified expenses such as tuition and fees, books and supplies, room and board, computers, or any other equipment required for class, then you’re going to pay the penalty.

2. Costly Fees in Some 529 Plans

Every state sponsored 529 plan is going to be different. Some will have higher fees and some others will have better 1-year, 5-year, or 10-year performance records.

There are many factors when determining which 529 plan and what fees are going to be appropriate for you. These factors depend on college preference, how many years away from college the beneficiary is, and your level of risk tolerance.

CollegeBacker is a great platform to help you decide which state-sponsored plan to choose from. 

Frequently Asked Questions

1. Can I have one 529 plan for multiple children?

No. Each 529 plan can only have one beneficiary. If you have multiple children, you will need to create a separate 529 plan for each child.

2. What colleges or schools can 529s be used for?

The IRS states that any college, university, trade school, or other post secondary educational institution eligible to participate in a student aid program run by the U.S. Department of Education.

This includes most accredited public, nonprofit and privately-owned–for-profit postsecondary institutions.

There are also hundreds of foreign colleges and universities where your 529 plan can be used. To determine if a foreign college is included, they must be eligible for Title IV federal student aid.

3. What are Qualified Educational Expenses?

• Qualified Educational Expenses
• Tuition
• Fees
• Books
• Equipment required for course enrollment
• Computers (if required by school or program)
• Room and Board

4. What happens if the beneficiary gets a scholarship or doesn’t need the 529 savings?

529 plans are very flexible and you can change the beneficiary to another (distant) family member of your choice at any time. For example, if your child gets a scholarship or doesn’t want to attend college, the 529 beneficiary can be changed to a family member (see list of qualified members above).

5. Can I open a 529 for my unborn child?

Yes, but there is a work-around. A 529 plan must have a living beneficiary with a social security number. What you can do is open the 529 and list yourself as the beneficiary. Once your child is born and has a social security number, you can then change the beneficiary from yourself to the child.

This is a popular way for parents to boost the savings early on when the child is born through financial gifts from friends and family members.

6. Does anyone who contributes to the 529 get the state tax deduction?

Yes. If your state offers a state tax-deduction, then anyone who saves into a 529 will receive the tax deduction. The tax deduction is based on the investor – not the 529 plan.

7. What is a Direct vs Advisor Sold 529 Plan?

You have the option to do-it-yourself, or you can have an advisor help you.

A Direct Sponsored Plan

This option will cost less because you are not paying an advisor for help. Anyone can open a 529 plan and if you bypass an advisor, you ultimately are responsible for determining how this plan is funded.

There are great DIY platforms such as CollegeBacker to help you choose the best 529 based on your overall risk tolerance.

An Advisor Sponsored Plan

This is where a financial advisor is paid to help you set up and manage the 529. The financial advisor will charge an additional fee and these fees can often range from 1% – 2% of the balance of your 529.

8. Will it Affect My Child’s Ability to Receive Financial Aid?

Yes, but it’s very minimal and in the long run you’ll benefit more from the tax advantages thank you will lose out from financial aid.

When you go to apply for financial aid, you will have to fill out a FAFSA (Free Application for Federal Student Aid).

The FAFSA will take a look at the student’s financial situation and their current assets to determine if they are eligible for financial aid.

However, since the 529 plan is actually owned by the parents and not the student, the educational institute will look at something else called the Expected Family Contribution (EFC).

In a nutshell, the higher the EFC, the less financial aid your child is going to receive.

The good news here is the school is only allowed to use 5.64% of the EFC to calculate eligibility requirements. When you compare this amount to the 20% they are allowed to use for the student’s own assets, I’ll take the 5.64% via a parent-owned 529 plan over the 20% calculation all day long.

Remember, the higher the EFC the lower the amount of financial aid.

Summary

Saving for college into a 529 plan is a great strategy for saving for college. With the tax benefits of tax-free growth and tax-free withdrawals, this ends up saving investors thousands of dollars over time.

However, saving for college should never come before more things such as building an emergency fund, paying off consumer debt, and investing into retirement. As much as I love saving into a 529 plan, I would never recommend saving for college before you have built a solid financial foundation.

If you’re someone who is currently paying down consumer debt such as credit cards, auto payments, personal loans, or student loans – push pause on saving into a 529 plan. Instead, pay off your debt, save up some cash reserves, start investing for retirement, and then open up the 529 plan.