Saving for your children’s college education is important, but are 529 plans the right way to do it? 529 plans have been the popular choice for college savings since their inception, but it is important to evaluate the pros and cons of these accounts and relate them to your family’s specific situation.
How 529 Plans Work
529 plans are savings plans operated by states specifically to fund higher education expenses. Nearly every state now has a 529 plan available, and you do not have to live in the state, or go to school in the state, to invest in that state’s plan.
There are 2 types of 529 plans:
- Prepaid Plans: These let you pre-pay part (or all) of the cost of a specific institution at their current tuition rate. These plans can have great advantages if you know what college your child will be attending, but since no one knows what the future holds, most people decide to use a Savings Plan instead.
- Savings Plans: These work like Roth IRAs, as you invest your contributions in mutual funds or similar investments. In terms of federal income tax, your contributions are not deductible, but they will grow tax deferred and can be withdrawn tax-free so long as the funds are used to pay for qualifying education expenses of the beneficiary. And depending on the state you live in, your contributions may actually be deductible on your state tax return.
The one big con to a 529 plan is that if it is not used for qualifying education expenses, earnings from any withdrawals will be taxed, and there will also be a 10% penalty applied. You can change the plan’s beneficiary from one child to another, or even to yourself, but if no one is going to school, there’s not much you can do to avoid the penalty.
This is why we recommend meeting with your financial advisor before funding a 529 plan. The advisor should work with you to figure out how much you want to contribute to your children’s education expenses, what school/expense amount to target, and how much you would need to fund over how many years to get to your desired goal. Your advisor may recommend a variety of tools to use in funding education as well, not just 529 plans.
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The Best 529 Plans
Since almost every state now has a 529 plan, and most plans are available to residents of any state, which do you choose? Here are some things to look for:
- Expenses. A low expense ratio is important for the growth of your account. A few states with the lowest-cost plans (open to anyone) are New York (0.17%), California ScholarShare (0.19%), and Nevada (0.21%).
- Variety of Investments. Alabama has an astonishing variety of investments from Pimco, Vanguard, T. Rowe Price and Fidelity. Although it has a higher expense ratio, Maine’s plan offers unique investment choices from BlackRock, Franklin Templeton, and even ETF portfolios with iShares. Finally, Utah’s plan offers a great assortment of investment choices, including Vanguard’s index funds (making it a great low-cost option) and a new set-it-once asset allocation tool that automatically changes your portfolio mix every year as your child gets older.
- Performance. Although past performance never guarantees future results, it’s interesting to note the top 2014 plan performers so far (according to savingforcollege.com) are New Jersey, District of Columbia, and California’s ScholarShare.
A 529 plan should not be your sole college funding vehicle. Depending on your family’s situation, consider other sources of funding, such as:
- UTMA/UGMA. Starting a custodial account for your child will allow you to save money for your minor child under their own name. The income from this account will be taxed under the child’s rate (subject to Kiddie Tax rules), which can save you some money. And these funds are not limited to education use which makes the account more flexible than a 529.
- Roth IRA. You can use withdrawals from your own Roth IRA to pay for qualified education expenses penalty free, just like a 529. However, keep in mind that having sufficient retirement funds for yourself is always more important than funding your child’s education.
- Scholarship. Probably the best way to pay for college education is a scholarship. Not only does it save you money, but your child feels a sense of accomplishment. As a bonus, the amount equivalent to the scholarship can be withdrawn from the child’s 529 penalty-free so as to incentivize hard work and merit. Search for awards here.
- Financial Aid: Loans and grants are probably the most popular way to pay for college. Keep in mind that UTMA/UGMAs count as the child’s assets and will affect financial aid eligibility more so than 529 Plans, which count as the parent’s assets.
Using a combination of these funding sources usually works best. You should work with your advisor to come up with a plan that makes sense for you.