With nearly $350 Billion in 529 plans around the country it is clearly the most widely used and preferred method of saving for college. 529’s live in a tax code that is much different than any other savings vehicle we have access to today. Does the money grow tax deferred? Yes. Are there taxes if the money is used for qualified educational purposes? Nope. Well how about being limited to a small annual contribution like a Roth? Nope again! Let’s dig into it.
529 plans are generally opened by a family member for a child or grandchild. With the costs of college rising having a plan for saving for college is just as important as saving for retirement.
So, what are a few benefits of owning a 529 plan?
– The largest benefit is the tax deferred growth as well as tax free distributions if used for qualified expenses. Think about it like a Roth IRA but dedicated just for college.
– The five-year election. This means you can contribute five years of the annual exclusion amount of $15,000 totaling $75,000 OR if done by spouses they can contribute double that up to $150,000 up front!
– As of 2017 you can use up to $10,000 per year for K-12 private school tuition- Certain states give tax deductions for contributions
– Beneficiaries can change over time. For example: you could have some money left in a 529 plan after college and your parents could change the beneficiary to your sibling to use the remainder of the plan assets
Now, potential drawbacks.
– You can only exchange the funds you are currently invested in twice per calendar year. You can adjust future contributions more frequently.
– Expenses. 529 plans historically have been only commission based with high fees. Now the fees are much lower and can be done in a fee-based environment further benefiting clients, this one is turning into a positive over time.
– The assets inside the plan are subject to financial aid considerations. Essentially the college looks at the 529 plan as assets used for college and can reduce potential financial aid packages.
A 529 plan is not right for everyone saving for college. Too often it is used as a blanket savings vehicle for everyone. One massive alternative is using a Roth to start saving for college. Parents do not know exactly what their children will do when it comes to higher education. Maybe they are more interested in working with their hands and going to a four-year university doesn’t fit their life goals. A Roth gives you other uses besides college. When using a Roth it is important to understand your basis (the money you put in) can come out at any time. The order withdrawals goes: contributions, conversions then earnings. For example: if I added $5,000 a year for 5 years my basis would be $25,000. I can take that money out at any time. Anything that was earned above that is considered gains which comes out last. However, paying for college with the gains (anything above basis) is taxable. In 2020 you can add $6,000 per year to a Roth, which over 18 years adds up to $108,000 of contributions, that can be left alone or used to pay for college. Keep in mind retirement accounts are not included in an available asset for financial aid purposes. This is another advantage a Roth has over a 529 plan.
So, what is right for me? In general, if someone is planning to use the five year exemption or any amount over $12,000 annually (one Roth per spouse) a 529 plan might be a better fit. If someone is only planning to put away $100 a month or any amount under the $6,000 maximum I believe a Roth might be a better fit. You have much more lower cost options to help increase portfolio return over time. This also gives the potential advantage of having a retirement account funded if your child does not attend college.
This is such an important topic and deserves much more than a blog about it. This is a very in-depth conversation I have with clients every time we are looking at college planning.
What are your thoughts?