What is a 529 plan and should I Use one for my kids education - education savings plan - Savology free financial planning

If you’re reading this right now, then give yourself a quick pat on the back. It means you’re taking the next step and are considering planning ahead for your children’s education.

A college education can be a great investment in your children to set them up for a successful career.

When it comes to preparing for college, tuition and other notable education expenses are great considerations. That’s where a 529 education savings plan can play a great role in maximizing your efforts and returns on saving for your children’s education.

Now you’re interested. You also likely have a lot of questions on how these types of plans can benefit you and how exactly they work. Let’s take a look at that below. 

What exactly is a 529 plan?

A 529 plan is a tax-advantaged type of investment vehicle that is primarily used as a way to encourage saving for the future higher education expenses of a designated beneficiary, like your own children.

529 savings plans are tax-advantaged in the sense that they provide a way for you to avoid paying income tax on any gains in the savings account as long as the funds are used for qualified educational expenses.

If the funds are not distributed and used for qualified educational expenses then that money is subject to income tax as well as a penalization that includes an 10% early-distribution penalty.

The good news though, is that there are a lot of expenses that would qualify. Qualified educational expenses include the following, not just for college, but for virtually all levels of education starting in elementary:

  • Tuition and tuition fees
  • Books, supplies, and equipment required for studies
  • Room and board 
  • Off-campus housing

Here’s an eye-opening and alarming statistic: In 2013, only 2.5% of all families across the United States had 529 college savings accounts. While this number has likely grown since then, it provides a very realistic picture of the need around financial literacy focused on these types of plans.

Are there different types of 529 plans?

Currently, there are two different types of 529 plans: prepaid plans and savings plans. 

  1. Prepaid plans

529 prepaid plans essentially allow you to purchase tuition credits at today’s rate which can then be used in the future. These plans can be administered by states or educational institutions.

  1. Savings plans

529 savings plans differ from prepaid plans in the sense that all growth is based upon the performance of the markets of the underlying investments, typically consisting of mutual funds.

It is a very common approach that most 529 savings plans offer a variety of age-based asset allocation options where the underlying investments become more conservative as the beneficiary gets closer to the age of using the allocated funds for their education as a way of protecting the money. 

Questions you need to ask yourself regarding 529 plans

Now that you have a better understanding of what exactly a 529 plan is, you need to start diving deeper into the details so you can understand if a 529 plan makes sense for your current and future situation.

Here are a few questions you should be asking yourself before deciding if a 529 plan is the right move:

How old are your children? 

If your children are still relatively young, a 529 savings plan can be a great tool. Like any investment account, the longer the money is in the account, the more benefit you will receive. 

If your children are older, and within a few years of starting their college careers, it may be too late to see any notable benefit from a 529 plan. If this is the case you should first consider federal pell grants before looking at student loans.

Are you saving for your retirement?

I often see people saving for their children’s education but neglecting their retirement. This can come at a significant cost and may be a disservice to your children. You are free to save and use your money in any way you desire, but with that being said, it’s in your best interest to always consider your priorities. The truth is that most Americans are not saving enough, or even at all, for retirement. 

Additionally, there are many alternatives when it comes to paying for education such as scholarships, working while in school, and community colleges. This is something that you should consider before you start allocating money towards a 529 plan. If you are unsure whether you are on track or not with your current retirement savings you can get a better understanding of that here

The Pros and Cons on 529 plans

Of all the tools available to save for your children’s education, a 529 plan is more often than not the best solution and the most flexible one as well. 

Here are some Pros and Cons of 529 plans that you need to be aware of:

Pros

  • 529 plans are considered an asset of the parent for financial aid purposes
  • You can invest 529 plans in a diversified portfolio of stocks and bonds 
  • Anyone can contribute to a 529 plan for your children, including other relatives 
  • Any appreciation in the assets value is tax free if used for qualified education expenses
  • You can fund up to $15,000 per year, per person contributing (as of 2020) 
  • You can prefund your 529 plan up to five years, allowing you to get a lot more money into the account and get more benefit. In 2020 you can fund it up to $75,000 per person contributing. 
  • Many states allow for income tax deductions of contributions to a 529 plan, learn more here.
  • There are no adjusted gross income (AGI) limits for who can participate in a 529 plan
  • You can change beneficiaries at any time (especially if you have more children)
  • Funds that are in a 529 plan are protected from creditors in most states 

Cons

  • There is a 10% penalty on the earnings, and the earnings are included in gross income, if not used for qualifying educational expenses – exceptions for the 10% penalty include distributions on account of death, disability, and scholarships for the beneficiary

Another added benefit to 529 savings plans is beginning in 2018, up to $10,000 of annual distributions may be taken from a 529 Plan to pay for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school. This rule change is a huge benefit to many people. This allows you more opportunities to put these funds to good use, especially if your child does not go on to pursuing a college education.

Alternatives to 529 plans

While 529 plans are seen as the most efficient and easiest way of saving for your children’s education, it’s important to note that there are alternative savings vehicles.

These alternatives include the following:

  • Roth IRA
  • Coverdell education savings account (ESA)
  • Uniform Gift To Minors Act 

Moving forward with your 529 plan

When it comes to your children’s education, much like your own financial plan, you can never be too prepared. Understanding and taking the right steps can help you set your children up for success, while also saving you time and money.

If you’re in the process of planning to invest in your children’s future and education, 529 plans are typically seen as the best and easiest way to save for their education, especially for those who have young children that are many years away from going to college.

Finally, it’s critical for your own financial plan to make sure that you continue doing your research and improving your financial understanding of the tools and resources available to you so that you can continue making the best financial decisions.


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