What’s the 411 on the 529?

‍What is the 529 strategy?

 Dear A Couple That Met in College, 

 First of all, props to you for thinking about your child’s education! 

 Attending college is considered one of the best ways to improve one’s chances of reaching financial success. An education is one of the smartest, and most thoughtful investments you can make for your kid. 

 A new database from the Georgetown University Center on Education and the Workforce calculated the Return on Investment (ROI) for students at more than 4,500 colleges—evaluated 10, 15, 20, 30, and 40 years after enrollment based on their lives after graduation. The data shows that going to college does typically pay off: an average of 60% of college students earn more than a high school graduate 10 years after enrolling in college

 The 529 is a college savings plan that helps you start saving for future educational expenses today, with major tax perks. Essentially, it’s Uncle Sam’s way of saying thank you for putting away money for school.

 It was created in 1996 and can be used to pay for educational expenses at any qualified college, trade school, or for up to $10,000 per year at a K-12 school. What's the benefit? You can save 20%+ on the total cost of college—which could add up to ~$200,000 in savings.

 Help your loved ones avoid the $1.7 trillion student loan debt crisis that has become a multi-generational problem in the US by saving through a 529! You can set aside money for anyone you want—including yourself.

Why go through the effort?

 Why bother saving money through a 529 when you can just stuff the savings under the couch? Here are three main reasons why a 529 is 100% worth it: 

Tax Free Distributions

The first major perk is that the money comes out tax-free! If you withdraw money from your 529 for an educational expense, that expense is exempt from federal income tax.  

More on what exactly qualifies as an educational expense in the FAQ section, but in a nutshell it covers tuition, fees, books, supplies, special needs equipment, computer, internet access, & room and board for higher education costs. The student has to be enrolled and pursuing a degree or certificate at least half-time.

 As of 2017, the 529 can also be used to cover up to $10,000 in K-12 tuition per year, per beneficiary, which is amazing news!

CalcXML has an online calculator that can help you estimate how much you would accumulate in a 529 plan versus a standard, taxable savings account. For example, if you were to contribute $5,000 a year to a 529 for 18 years, you would accumulate $202,231 in a 529 plan compared to $167,952 if you contributed the same amount to a taxable savings account.

Tax-Deferred Growth 

Under a 529 Savings Plan, your contribution can grow tax-deferred. Plain-talk: the money you earn from your 529 will not be subject to federal or state income taxes, as long as it remains in the plan. This means that all of the earnings are reinvested and will grow tax-free in a 529, compared to a Robinhood or Vanguard account where you have to pay taxes on your investments every year. 

Upfront Tax Deduction (*in most states)

The cherry on top is that in 33 out of 50 states, the 529 comes with an upfront state income tax deduction. Immediate gratification for going with a 529. Most of the time, you have to contribute to your home state’s 529 plan to qualify for the state income tax deduction, but there’s a handful of states that will still give you the tax benefit regardless of what 529 plan you contribute to. Check out this article by Bankrate for a compiled list of states and whether or not they offer the upfront deduction. 

Why choose the 529 vs. other accounts to save for kids (e.g., UGMA/UTMA)?

Before we highlight how awesome the 529 is, let’s start with a lay of the land on where you can invest for your kid. 

Where can you invest for your kid?

Here are the five main options, in order of our preference:

1. Roth IRA Account for Your Kid: A Roth IRA is one of the best investment vehicles for your child’s future wealth. The only catch is that you can only open up an account for your kid once they reach working age. A child has to earn income in order to open a Roth IRA account, so the wait is the only catch.
2. 529 Savings Plan: What this blog post is devoted to :)
3. Investing Account (fully owned by the parent): This method involves the parent investing in an account that they own, but earmarks for their kid. In finance speak, this means setting up the minor as a “beneficiary”. 
4. Trust Account: We all know what a trust-fund baby is… This option is reasonable if you’re setting aside $16,000 or more a year for your kids. Then it would make sense to bring in an attorney and set up a trust.
5. UGMA/UTMA Account: Standing for Uniform Gifts/Transfers to Minors Act, this method is a relic of pre-529 times. Nicknamed “Ferrari Accounts”, they are often misused by the child once they get access to the money at the age of 21. Since there are no rules for how the money has to be spent, the recipient of UGMA money usually splurges on sports cars and luxury items vs. education expenses. The difference between a UGMA and a UTMA account is that a UTMA can include real estate investments and property, while the UGMA account can only hold financial products like stocks & bonds.

Pros of a 529:

Better tax benefits.

• The tax-free distribution, tax-deferred growth, and upfront tax deduction combo makes the 529 a hot package. 

Flexibility.

• You can easily change the beneficiary on the account, in case your kid becomes a breakout pop star and decides to tour the world instead of going to college.
• You can contribute as little as $25 / month.
• It’s applicable to any K-12 (for up to $10k a year) or any college, even if it’s outside the state where you set up the 529.

Control.

• No sports cars here! With a 529, the money doesn’t automatically get handed over to your kid at 21.
• There are (good) restrictions to how the money is spent.

Doesn’t risk financial aid.

• Having money in a UGMA account can screw with a kid’s financial aid package. 

Doesn’t risk “kiddie tax”.

• For UTMA accounts, the first $2,100 in unearned income may be tax-free, but anything over gets taxed at the estate/trust rate. This is called the “kiddie tax”.

Gifting benefits.

• With a 529, you can super fund the account meaning you can fund 5 years worth of contributions in one year alone. So you can contribute up to $16,000 x 5 = $80,000 in one year.
• 529s are also great for grandparents who want to “gift” their grandchildren an education. As of 2021, distributions from a grandparent’s 529 have no impact on financial aid eligibility.

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How do I set one up?

If your state offers a deduction:

If your state offers the upfront deduction (check out this Bankrate article to find out), then we recommend you invest in your state’s local 529 program. That way you’ll get the tax deduction each year for contributing, in addition to the longer-term tax-deferral and tax-free withdrawal that the 529 offers. Choosing which state you enroll in just means that that state will administer the 529. Your kid does NOT have to attend school in the state. The money can be used to pay qualified higher education expenses at any eligible school anywhere in the US or abroad, or to pay expenses for K-12 tuition for up to $10,000 per year per beneficiary. You can find out more about your state's plan here. 

If your state does not offer a deduction:

Even if your state does not offer the upfront deduction or tax credit, it’s still worth investing in a 529. You still get double-tax savings via tax-free growth and tax-free withdrawals. Plus, you can enroll in any other state’s 529; it doesn’t have to be your home state because your child can use the 529 to attend school in any state. The NY 529 plan is available to residents of any state, and is made up of low-cost high-performance Vanguard funds. Runner-up plan to consider would be Utah's. 

How much should I contribute?

Start saving for your kid’s education from when they’re a newborn. Time is of the essence, so it’s important to get started as early as possible. We recommend the following savings amounts depending on the education you’re imagining for your child:

• $250 / month — Public In State 
• $450 / month — Public Out of State 
• $550 / month — Private

There’s no official contribution limit for 529s. However, to avoid triggering a gift-tax, you should give no more than $16,000 per donor (parent), per beneficiary (child) each year. This ensures the gift to the 529 is tax-free. 

Alternatively each adult could make a lump-sum contribution of up to $80,000 to a beneficiary's 529 account, and elect to treat it as if it were made evenly over a 5-year period, gift-tax free. As long as you don’t make additional contributions in the 5-year period, you won’t trigger the gift tax. The lump-sum, or superfunding, method gets your savings compounding tax-free sooner! It’s a popular approach taken by some grandparents who are looking to do tax-efficient gifting to grandchildren!

If you’ve stumbled upon this blog post in the midst of saving up for your kid’s education and are unsure if the amount you have saved right now is enough, here’s a quick way to calculate how much you should have saved currently:

Multiply the age of your child by: 

• $3,000 for Public In State
• $5,000 for Public Out of State
• $7,000 for Private

Ideally, that’s how much you should have saved right now for your kid’s education. Totally okay if you’re not there yet, but time is of the essence when it comes to saving, so let’s get you caught up.

If you’re looking for a more detailed calculation, Steward has a College Savings Calculator that will recommend an annual savings amount for your kid’s education. We calculate your recommended contribution based on 8 factors: your child's current age (or roughly when you're planning to add a child to your family), expected age of starting college (18), expected years in college (4), the current annual college cost for the school type of your choice, what level of funding you'd like to provide, baking in the annual maximum an individual can contribute to a beneficiary without invoking the gift-tax ($16,000), rate of annual cost increase based on history (5%), and the historical avg. rate of return of the investments we suggested for you (6%). Check out the calculator here.

When should I contribute?

Once each year (e.g., in January, after your bonus or additional income hits, or in April, after you pay taxes). But if you are taking the lump-sum superfunding route, then you would contribute $80,000 every 5 years.

What investments should I choose?

 We recommend that you invest in something called a target date fund. Usually used for retirement, this fund can also be used for your child’s education. This type of fund will “target” the year your child turns 18 and starts college, and will adjust your diversification and risk based on how fast the target date is approaching. The fund’s allocation will become increasingly conservative as the target year approaches to ensure you have a healthy balance of wealth creation and wealth protection. The diversified portfolio might look something like this: 90% stocks / 10% bonds when your kid is a newborn, 50% / 50% when your kid is around 10 or 11 years old, and then a more conservative 80% bond / 20% stocks allocation right before they start college. Low fees are key when it comes to picking a target date fund. Check out Vanguard’s target date funds here.  

What are the strings attached?

You'll need to use the money towards educational expenses. More on what counts as a qualified expense in the FAQ section below. If you take a non-qualified withdrawal, you’ll have to pay income tax and a 10% penalty on the earnings portion of the withdrawal. 

FAQs?

What are qualified expenses for the 529?

529 plans must be used for educational expenses. They can be used tax and penalty free for tuition, room & board, books, approved supplies, fees, special needs equipment, internet access, and computer technology at any private or public US college, community college, or trade school. It can be used for certain international colleges. Additionally, you can now use the 529 for qualified vocational and graduate school education, as well as up to $10,000 per year for K-12 school expenses. It can also be used for up to $10,000 in student loan repayment. Check out this article for a more detailed list of what counts as a qualified expense.

Can I change the beneficiary?

Yes, you can change your beneficiary or transfer a portion of your investment to a different beneficiary at any time. To make this transfer tax-free, the new beneficiary must be a member of the previous beneficiary’s family, as defined by the Internal Revenue Code. The definition of "family" is quite broad and includes the beneficiary's: son, daughter, stepchild, foster child, adopted child, or a descendant of any of them;  brother, sister, stepbrother, or stepsister; father, mother, or ancestor of either; stepfather or stepmother; niece or nephew; aunt or uncle; son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; the spouse of the beneficiary or any individual listed above; or first cousin! 

Do I need to open a 529 for each of my children? Would one be enough for the whole family?

You could use one college savings plan account for all your children, but unless they’re twins, it's likely not the best strategy. If your children have different time horizons, you may want to consider adopting different investment strategies for each of them. Even if they are twins, each child might want to take a different path for their education. Therefore, opening an account for each child allows you to help them pursue their dreams according to their unique education timelines. There is no annual fee to open and maintain an account no matter how many accounts you open. For added flexibility, funds can be transferred between beneficiaries as needed.

What if my kid doesn’t go to college?

You can change the beneficiary of the 529 at any time. If you choose to withdraw the funds, note that you’ll have to pay income tax and a 10% penalty on the earnings portion of the distribution.

Can I contribute before kids?

If you're planning for a baby in the near future, but don't yet have a child, you can still contribute to a 529. This is really a matter of personal choice! Some folks prefer to wait until the baby is born to start funding, and others find it helpful to 'set-and-forget' before the baby arrives just so they have one less thing on their plate once they become parents. 

Personally, I’d wait to open a 529 college savings plan until your child is born. Just make sure to set yourself a reminder. Sleep deprivation from a newborn is a given and could cause you to forget.

If you choose to fund one, just set the beneficiary as yourself for now, and you can adjust the beneficiary to your child's name in the future. You can always adjust the beneficiary of the 529 plan to another family member (nieces, nephews etc.) or even yourself (e.g., for continuing education classes or even educational cruises) in case your plans for a baby change.

If my child gets a scholarship (academic or athletic), will I lose the money in my account?

 If the beneficiary receives a scholarship, or if the cost of attendance is lower than expected, there are several options available:

• 529 plans can be used to pay any qualified education-related expenses not covered by the scholarship, such as room and board, books, supplies, computer technology, and equipment. 
• You could also change beneficiaries and transfer any unused funds to an eligible family member.
• Save the unused money for graduate school.
• In the case of a scholarship, nonqualified withdrawals up to the amount of the tax-free scholarship can be taken penalty-free, but you’ll have to pay income tax on any earnings.

If I save with a 529, will my child be able to receive financial aid?

While the money you save with a 529 will be taken into consideration when determining what your child's financial aid will be, the impact is likely minimal, as a 529 is considered a parental asset, not a student asset. A 529 plan owned by a custodial parent or dependent student typically counts as a parent's investment on the FAFSA, and it may reduce need-based aid by a maximum of 5.64% of the 529 account’s value. 

Although some of the aid you may get through the FAFSA could be grants, financial aid may also be offered in the form of loans, which must be repaid with interest. Therefore, 529 account savings will likely have a minimal impact on your financial aid and offer the potential to reduce most families' dependence on student loans.

Should I choose age-based funds or target-date funds?

Many 529 plans are switching from age-based glide paths that make big (e.g., 10%+) shifts at set ages to more target-date-style funds that make smaller more frequency changes (which reduces the timing sensitivity), so we recommend going with target-date funds.

What if there is money left over?

 You have several options:

• You could also change beneficiary and transfer any unused funds to an eligible family member.
• Save the unused money for graduate school.
• In the case of a scholarship, nonqualified withdrawals up to the amount of the tax-free scholarship can be taken penalty-free, but you’ll have to pay income tax on any earnings.
• If there’s no scholarship and you choose to withdraw the left over money, you’ll have to pay income tax and a 10% penalty on the earnings portion of the distribution.

Do you need to get a 529 plan from your state?

 No! You can get a 529 plan from any state, because the beneficiary can choose to attend school in any state regardless of where the 529 plan is registered. The state you choose to set up the 529 plan in only administers the plan. However, over two thirds of states have the upfront tax deduction in their 529 plan, so it’s worth choosing the state strategically.

What’s the best 529 plan?

 Here’s a list of the best 529 plans by Morningstar, one of the most trusted financial researchers. 

As you can see from the chart, 529 plans from Nevada, Utah, Virginia, Maryland, or Arkansas are rated gold or were once rated gold, so those are definitely ones to look into. But because you can use the funds for an education in any state, I wouldn’t spend too much time stressing over which one to choose.

Are these popular?

The popularity of 529 plans is rising as the plans become more flexible! The list of qualified expenses continues to grow and in 2017, Congress expanded the plan to include up to $10k per year for K-12 expenses and up to $10k in student loan debt. Additionally, fees for 529s have been going down. However, advisor-sold plans are still more expensive, by an average of 0.54%, as the advisor is compensated for their own services. Thus far, 529 plans continue to skew towards wealthier clients, but that’s why Steward is here to share these financial hacks with the 99%.

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Other Resources

Here are some other resources you should check out when it comes to 529s and also planning for your child’s college education in general: 

Fidelity's ABCs of College Savings Plans

The SEC's Intro to 529 Plans

Saving for College Website

Student Loan Hero's Different Ways for Paying for College

Forbes's How Much to Save for Child's College Education

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