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529 plans



The 529 college savings plan is a tax-advantaged investment account meant specifically for education expenses. As of the passage of the Tax Cuts and Jobs Act (in 2017), 529 plans can be used for college costs, K-12 public school costs, or private and/or religious school tuition. If you will ever need to pay for your children’s education, then 529 plans are for you.

529 plans are named in a similar fashion as the famous 401(k). That is, the name comes from the specific U.S. tax code where the plan was written into law. It’s in Section 529 of Internal Revenue Code 26. Wow—that’s boring!

But it turns out that 529 plans are a strange amalgam of federal rules and state rules. Let’s start breaking that down.



Tax Advantages


Taxes are important! 529 college savings plans provide tax advantages in a manner similar to Roth accounts (i.e., different than traditional 401(k) accounts). In a 529 plan, you pay all your normal taxes today. Your contributions to the 529 plan, therefore, are made with after-tax dollars.

Any investment you make within your 529 plan is then allowed to grow tax-free. Future withdrawals—used for qualified education expenses—are also tax-free. Pay now, save later.

But wait! Those are just the federal income tax benefits. Many individual states offer state tax benefits to people participating in 529 plans. As of this writing, 34 states and Washington D.C. offer these benefits. Of the 16 states not participating, nine of those do not have any state income tax. The seven remaining states—California, Delaware, Hawaii, Kentucky, Maine, New Jersey, and North Carolina—all have state income taxes, yet do not offer income tax benefits to their 529 plan participants. Boo!

This makes 529 plans an oddity. There’s a Federal-level tax advantage that applies to everyone. And then there might be a state-level tax advantage depending on which state you use to set up your plan.



Two Types of 529 Plans


The most common 529 plan is the college savings program. The less common 529 is the prepaid tuition program.


The savings program can be thought of as a parallel to common retirement investing accounts. A person can put money into their 529 plan today. They can invest that money in a few different ways (details further in the article). At a later date, they can then use the full value of their account at any eligible institution—in-state or out of state. The value of their 529 plan will be dependent on their investment choices and how those investments perform.


The prepaid program is a little different. This plan is only offered by certain states (currently only 10 are accepting new applicants) and even by some individual colleges/universities. The prepaid program permits citizens to buy tuition credits at today’s tuition rates. Those credits can then be used in the future at in-state universities. However, using these credits outside of the state they were bought in may result in not getting full value of your dollars.


You do not choose investments in the prepaid program. You just buy credits today that can be redeemed in the future.


The savings program is universal, flexible, and grows based on your investments.


The prepaid program is not offered everywhere, works best at in-state universities, and grows based on how quickly tuition is changing (i.e., the difference between today’s tuition rate and the future tuition rate when you use the credit.)


Example: a prepaid credit would have cost ~$13,000 for one year of tuition in 2000. That credit would have been worth ~$24,000 of value if used in 2018.



What are “Qualified Education Expenses?”


You can only spend your 529 plan dollars on “qualified education expenses.” Turns out, just about anything associated with education costs can be paid for using 529 plan funds. Qualified education expenses include:


· Tuition


· Fees


· Books


· Supplies


· Room and board (as long as the beneficiary attends school at least half-time). Off-campus housing is even covered, as long as it is less expensive than on-campus housing.


Student loans and student loan interest were added to this list in 2019, but there’s a lifetime limit of $10,000 per person.



How Do You “Invest” Your 529 Plan Funds?


529 savings plans do more than save. Their real power is as a college investment plan. So, how can you “invest” this tax-advantaged money?


There is a two-part answer to how your 529 plan funds are invested. The first part is that only savings plans can be invested, not prepaid plans. The second part is that it depends on what state you are in.


For example, let’s look at New York. It offers both age-based options and individual portfolios.

The age-based option places your 529 plan on one of three tracks: aggressive, moderate, or conservative. As your child ages, the portfolio will automatically re-balance based on the track you have chosen.


The aggressive option will hold more stocks for longer into your child’s life—higher risk, higher rewards. The conservative option will skew towards bonds and short-term reserves. In all cases, the goal is to provide some level of growth in the early years, and some level of stability in later years.


The individual portfolios are similar to the age-based option but do not automatically re-balance. There are aggressive and conservative and middle-ground choices. Thankfully, you can move funds from one portfolio to another up to twice per year. This allowed rebalancing is how you can achieve the correct risk posture.



Advantages & Disadvantages of Using a 529 Plan


The advantages of using the 529 as a college investment plan are clear. First, there’s the tax-advantaged nature of it, likely saving you tens of thousands of dollars. Another benefit is the aforementioned ease of investing using low-maintenance, age-based investing accounts. Most states offer them.


Other advantages include the high maximum contribution limit (ranging by state, from a low of $235K to a high of $529K), the reasonable financial aid treatment, and, of course, the flexibility.

If your child does not end up using their 529 plan, you can transfer it to another relative. If you do not like your state’s 529 offerings, you can open an account in a different state. You can even use your 529 plan to pay for primary education at a private school or a religious school.


But the 529 plan is not perfect. There are disadvantages too.


For example, the prepaid 529 plan involves a considerable up-front cost—in the realm of $100,000 over four years. That’s a lot of money. Also, your proactive saving today ends up affecting your child’s financial aid package in the future. It feels a bit like a punishment for being responsible. That ain’t right!


Of course, a 529 plan is not a normal investment account. If you do not use the money for educational purposes, you will face a penalty. And if you want to hand-pick your 529 investments? Well, you cannot do that. Similar to many 401(k) programs, your state’s 529 program probably only offers a few different fund choices.


In summary, 529 plans can be a fantastic part of your long-term financial plan, specifically if you plan on helping pay for future education. Most people will save on taxes now and will see their investment grow tax-free, enabling more education dollars for their family’s future.