A few of my friends who just had or are about to have
babies are asking me about 529 plans and whether it is worth opening one. Like everything else in financial planning, it
depends, but this would be a great time to discuss what 529 plans are and when
it makes sense to open them.
What
is this thing?
A 529 account is a savings account designed for higher
education. That’s it. It’s that simple. You put some money in, the money grows,
and your child uses it years down the road to go to college. You often hear the words “tax exempt” or “tax
advantage” but make sure you are clear exactly what that really means. A 529 does not work like a 401(k). Your
current taxes will NOT go down if you contribute to it. However, as long as you
take the money for what the IRS defines as qualified education expenses[1], all the interest that has
been accumulated will be tax free. This is a great advantage in some cases.
A 529 is a general blanket term that may refer to a
savings plan or a prepaid tuition plan. Above, I am referring to the “savings”
plan. Some states have a program where you prepay the tuition and your child
can go to any in-state school for free. That is NOT what I am referring to in
this post. Here is a good guide the state of FL put for us about the
differences. If your state offers both, think about your baby and where he or
she will be years down the road before making this choice: http://www.myfloridaprepaid.com/learning-center/savings-vs-prepaid-plans/
Is
a 529 plan worth it?
So let’s get back to the 529 savings plan that lets
you use the money anywhere you want. When
young parents ask me what’s better, a 529 plan or a savings account, the answer
will always depend on “what exactly do you need this money for?” Obviously no
one knows; your baby was born 5 days ago but if you are the type of family
where going to college is not a choice and the money will indeed be used for
college, a 529 open at birth wins. Why
is that?
The primary driver is the time you got on your hands.
18 years of tax free growth is a very long time… assume you deposit $1,000
today, at birth, and earn a pretty low rate of 5%. In 18 years, this amount will
be worth 2.41 times more and the extra $1,406 will be tax free.
The same conversation, however, will be very different
with someone who has a freshman in high school. The 3-4 years left before
college will usually not give you enough returns and tax benefits to justify
locking your money into a very specific purpose. Bottom line, the longer the
time between now and college, the more attractive a 529 looks. This means that if your baby was born 5
minutes ago, today is the best time to establish a 529 savings plan. Ok, you can
wait until tomorrow; you can have 24 hours with your brand new baby.
What
to consider
Assuming that you decide to open a 529 plan, the next question
becomes, which one? Every financial institution is going to try to sell you something.
As you are deciding between them, here are a few things to consider:
Does your state offer a STATE tax incentive? We
already know that the federal government does not, but some states do. See the footnote
for a list but I can’t guarantee it’s the most up to date. Please check with your
state. I can tell you that California does not incentivize this type of savings
behavior.[1]
What are the investment options (and fees) in that plan?
I am much more aware of fees than performance because we all know about the
risk-return relationship. Googling “best performing 529 plans” is probably not
the way to approach this topic. Just because you live in one state does not
mean that you need to open a 529 account with that state. Actually, in many
cases, you should not. I am a big fan of Utah’s plan but the first few ranked Google
searches didn’t even show me that one. Michigan, on the other hand, appears in
many rankings and yes, it is a great plan too. Be aware of fees and be aware of
what you invest in (you know I am not a fan of target or age-based plans). An
extra 0.10% in costs over 18 years makes a big difference and in many cases,
the difference is much more impactful than the tax savings at the state level. If you don’t know how to approach this, find a
fee-only advisor who can help you out for a few hundred dollars. It is so worth
the cost of having a few thousand dollars more in the end.
Consider what would happen if Little Johnny doesn’t go
to college. You do have options. The money will not be lost. The easiest is to
roll it to another beneficiary. If you have multiple kids, the problem is
pretty much solved. One of them will probably use it. It does not have to go to
a child. Here is a list of relatives it can go to (see under members of
beneficiary family): https://www.irs.gov/publications/p970/ch08.html#en_US_2015_publink1000178530https://www.irs.gov/publications/p970/ch08.html#en_US_2015_publink1000178530
But what if no one can use it, can you take the money
back? Yes, you can but anything you take out that is not for education expenses
will be taxed and penalized by the IRS.
One of the arguments I hear against 529 plans is that
you will minimize your FAFSA financial aid. Will it impact financial aid?
Probably. It will impact the expected family contribution (EFC). Should you be
concerned? I am not so sure about that. You need to think about your tax
bracket and if it even matters for your family. I am pretty sure if I ever open
any 529 accounts for my kids, it will not make much difference given my income and
plans for their college. But you should be aware of this possibility
so it does not take you by surprise.
Questions? Anything else I missed? I say, if you have
a new baby, go for it, open a 529 plan and ask all your relatives to deposit
money into it for birthdays and Christmases. Right now, Little Jonny might not
appreciate the effect of compounded interest but in 20 years, he will understand
what a great parent you are. That 529 plan will certainly be worth more than
another firetruck or reindeer. And yes, my baby will be getting a 529 plan as
soon as he is born. He is also (hopefully) going to save it for medical school
because he will get enough AP classes to skip the first 2 years of college and go
to whichever in-state public school I work for free for his undergrad. But that’s
my plan. You can call me in 18 years and asked me how it worked out.
[1] http://www.savingforcollege.com/compare_529_plans/index.php?plan_question_ids%5B%5D=437&mode=Compare&page=compare_plan_questions&plan_type_id=
and here is a nice, color coordinated
map to show you which states are the best at this: https://www.google.com/imgres?imgurl=https://dj2ioc7lf8iun.cloudfront.net/images/articles/original-20160811-state-tax.jpg&imgrefurl=http://www.savingforcollege.com/articles/how-much-is-your-states-529-plan-tax-deduction-really-worth-733&h=2127&w=3156&tbnid=YtG59Oz5R79xYM:&tbnh=143&tbnw=214&docid=U0UqZWtbIpcx7M&usg=__MgB3qJKVQBoiLuOYmywhJMu7bz8=&sa=X&sqi=2&ved=0ahUKEwi7xZqd59HPAhUCyWMKHdG3D1kQ9QEILDAA
[1] See the section below what
constitutes qualified education expenses https://www.irs.gov/publications/p970/ch08.html
