As a financial planner, I’ve done a lot of research on 529 plans before our son was born. A month after his birth, I set up a 529 plan for him and started making automatic monthly contributions into the account. I knew that the earlier I get into the habit of saving for college, the faster it will grow, and I don’t even miss it because it’s been a part of our budget for so long. Over the years, I’ve also come across several common misconceptions about 529 plans that make families hesitate on starting a college savings fund. Below is a summary of why I think the benefits of a 529 plan outweigh the potential benefits of alternative college savings vehicles.
Tax Advantages – Investments in a 529 plan grow tax deferred and potentially tax free if the funds are used for qualified higher education expenses. For example, let’s say you contribute $1,000 each year into the 529 plan over 18 years ($18,000 total invested), and when your child goes to college you have $30,000 in the account. The $12,000 of growth in the account is not taxable if you use the funds towards higher education. The earlier you start contributions, the more tax-free growth potential.
An alternative to 529 plans with similar tax advantages is the Roth IRA. Money invested in a Roth IRA grows tax free if withdrawn after 59 ½. So this strategy only works if you started having children in your 40s. If you have your first child at age 35, by the time they go to college you are only 53 and can’t take advantage of the tax benefit your Roth IRA. Furthermore, each person can contribute a maximum of $5,500 a year before age 50 ($6,500 after age 50) into a Roth IRA, and if your income is above a certain limit per IRS guidelines, you cannot contribute to a Roth IRA at all. For these reasons, I like the 529 plan better as a college savings vehicle. It separates the college savings fund from your retirement fund and makes it easier to plan for the future.
Flexibility – Each state offers 529 plans but most will allow non-residents to open an account as well. For example, you don’t have to live in Utah to open a Utah 529 plan. By having this flexibility, you can shop around and compare the various plans that are available to determine which one fits your needs. Furthermore, once you decide on the 529 plan, you can decide how to invest the money by choosing from the plan’s investment options (similar to a 401k plan).
One of the most common reasons I hear from parents for not setting up a 529 plan is the possibility that their child will not attend college. While that may be a real possibility for some families (for example, the child has special needs), it’s highly unlikely in most of my clients’ cases. Most people think they can only use 529 plans toward 4-year college educations, but in reality it’s much more accessible! There are over 6,000 eligible schools, including trade schools, community colleges, and even international and online schools. Here is a link to get the full list of schools available: https://ifap.ed.gov/ifap/fedSchoolCodeList.jsp.
Control of Assets – The owner of the 529 plan is the adult, and the child is the beneficiary. As the owner, you can change the beneficiary to another family member if the child no longer needs money for higher education. In addition, the beneficiaries have no control over the assets so they can’t use the funds as they wish once they become adults. This is also why 529 plan assets are considered assets of the parent rather than the child for financial aid purposes (which is much more beneficial for the family). For these reasons, I highly favor 529 plans over UTMAs (custodial accounts), which are considered assets of the child for financial aid. Furthermore, they gain complete control over the account once they become 18 or 21 depending on the state, and may choose to not use the funds for higher education as you had intended.
Simplicity – Finally, I like 529 plans because they are simple to understand. Each account is for a specific child’s higher education, so it’s easy to see how much you’ve saved for this purpose. By using vehicles other than 529 plans, such as Roth IRAs or whole life insurance (which is so complicated that it deserves its own blog post), there may be other factors that you need to take into account in order to use the funds properly without triggering any unfavorable consequences.