What is a 529 Plan?: A look at the pros and cons

You think college is expensive now – in 2036, it’s estimated that four years at a top-tier school will cost a whopping $490,000, compared to around $290,000 now.

Yup, that means college is going to double for the next few generations.

So, Millennial parents need to save NOW if they ever want to send their kids to college someday.

One of the most common ways to do this is through a 529 plan. This, however, isn’t always the best way to save for college.

A 529 is a college savings plan, known as a qualified tuition plan, that allows you to save money for your child’s college education. By doing so, you get to have your money grow without paying federal income tax on it (no capital gains tax and no tax upon withdrawal).

Named after the section of the Internal Revenue Code that it falls under, 529 plans are sponsored by states. This means that each state has different plan options. However, you are not limited to your state’s plan (you can contribute to a 529 savings plan in any state that offers one).

Additionally, a 529 plan can be used for schooling in another state. For example, if you live in Tennessee, you can contribute to a Virginia 529 plan and use the funds for qualified higher education expenses in California. Use this page to find out which states have the best 529 plans.

If you want to qualify for the prepaid tuition plan (also known as a prepaid 529), there are some residency requirements. This prepaid plan effectively lets you lock in current tuition rates, so you won’t need to pay for the cost of inflation down the line. You can learn more about this specific plan here.

• Tax breaks. 529 plans typically offer you a tax benefit. Earnings in a 529 plan grow tax-free and are not taxed when they’re withdrawn. This means that however much your money grows in a 529, you’ll never have to pay taxes on it.
• You have complete control over the funds. Another benefit of using a 529 plan is that you, as the owner, have control of the funds. The named beneficiary (presumably your child) does not have control of the money in a 529 college savings plan. This is a big benefit because you can make sure the money is used for its intended purpose.
• There are no income limits. A 529 plan does not have income limits. Regardless of how much money you make, you can continue to contribute to a 529 plan. There are, however, some limits on how much you can contribute each year. If you put more than $15,000 into a 529 plan for someone else, you may have to pay gift tax on the contribution.
• You can start saving now (even if you don’t have a kid). You don’t have to wait until your child is born to start saving money for their education. You can start a 529 plan, list yourself as the beneficiary, and then add your child as the beneficiary once they’re born.

• Colleges consider 529 money in financial aid packages. This means that your child could receive less financial aid for having money in a 529 plan. Not all savings vehicles are like this. If you put that same money in a Roth IRA, for example, it would not be included in your child’s financial aid package.
• You’ll pay a huge fee if you don’t use the money to pay for college. If you choose to withdraw money from a 529 account and use it for something other than its intended purpose, you will pay regular federal tax as well as a 10% penalty tax on the earnings.

529 plans may be a good fit for you in some circumstances. 

First, they can be beneficial today if you live in a state that offers state tax benefits for contributing to your state’s 529 plan. Check with your state to see if you qualify for any tax benefits.

529 plans can also work well for those that know their child will be going to college without a doubt. Due to the way 529 plans are structured, the money must be used for a qualified expense (like tuition expenses, for example). If it isn’t, you’ll have to pay taxes and a 10% penalty on the earnings when you withdraw them.

529 plans aren’t a good fit for everyone. If you live in a state without state income tax or no state tax benefits for using a 529, the only benefit you get is the tax-free benefit on earnings. 

Depending on your situation, it may make more sense to invest in another way rather than choosing a 529 plan. If you hold investments for over a year, you may qualify for the lower capital gains tax rates, which in some cases can be as low as 0%. 

When you combine the lower capital gains tax rates with no penalty for withdrawal for non-qualifying expenses, it’s easy to see other options that can provide more flexibility.

In addition, if you’re unsure whether your children will attend college, you can avoid the 10% penalty for any unused funds by using some other investment options.

529 plans aren’t the only way you can save or pay for college. You have plenty of options depending on your goals and other circumstances.

Taxable investment account

If you prefer being able to use the money you invest for anything without the worry of a penalty, a taxable investment account may work for you. You’ll have to pay taxes on any dividends, interest, or capital gains you receive on your investments. Even so, the long-term capital gains tax rates are currently more favorable than ordinary income tax rates.

Taxable investment accounts also allow you to invest in whatever you wish. 529 accounts may only offer certain investment types that may not be the best fit for achieving your goals.

Roth IRA

Roth IRAs provide another tax-advantaged way to save for college. Funds you put in a Roth IRA don’t give you a tax deduction. That said, earnings that are withdrawn may be tax and penalty-free in certain cases if you use them to pay for qualified education expenses.

In order for earnings to be both tax and penalty-free, you must have held the Roth IRA for five years or more. If your Roth IRA is less than five years old at the time of withdrawal, you won’t have to pay the 10% early withdrawal penalty. You will have to pay income taxes on the earnings, though.

Using a Roth IRA to save for college may seem like a smart move, but it can put you in a bad position if you haven’t adequately saved for your retirement. You can take out loans to fund college costs, but you can’t take out a loan to retire.

Coverdell Education Savings Accounts (ESAs)

Coverdell Education Savings Accounts, commonly referred to as ESAs, are another way to set money aside for qualifying education expenses. The benefit of these accounts is that you can open them wherever they are offered. They aren’t restricted by a state program. 

The downsides are there are limits to the amount you can contribute each year (just $2,000) and you can only contribute to them if your income is below a certain amount. 

Like with 529s, the money grows tax-free and you don’t get a tax deduction for contributions. You also have to pay taxes and a 10% penalty if you don’t use the funds for qualified education expenses.

Savings account

A savings account can be a suitable way to save for near-term college costs in states that don’t offer tax benefits for 529 plans. so, If you’ll need the money in under five years or so, a savings account may be a perfect choice. A savings account won’t pay you an amazing interest rate, but you don’t risk losing money, either. 

Look for a high-yield online savings account to get the most interest on your savings. While the interest is taxable, it won’t likely be enough to make a big difference.

A savings account also offers flexibility should your child decide not to go to college. You can choose to gift them the funds you saved to help them start their life or use it for anything else you may want.

Student loans

The federal government offers student loans up to a certain amount each year of college for qualifying students. These federal student loans have certain protections, many repayment options after graduation, and other useful features that private student loans do not. 

Even so, you don’t want to take out any more student loan debt than is necessary to complete the degree program. Unfortunately, federal student loans don’t always provide enough to cover all college costs in every case. 

When this happens, you may have to turn to private student loans. 

Everyone should be careful when taking out student loans, though. Make sure you (and the student) understand exactly how much they’ll have to pay back and have an idea of a starting salary that is reasonable after graduation.

It’s hard to find a perfect college savings vehicle, but saving money imperfectly is still much better than not saving at all. On the one hand, 529 money will be counted against your child’s financial aid. On the other hand, the 529 plan offers a big tax advantage and control. 

A 529 plan can be a good education savings plan for many families looking to save for college. It isn’t the right answer for everyone, though.

Check your state’s 529 plan to see if it offers any tax benefits that make it worth considering. Then, consider your other options before deciding how to save money for college costs. If you’re unsure which is best for you, consult a fiduciary financial planner for assistance with your specific circumstances.

Consider the pros and cons of each option you have, but don’t let the decision stop you from putting aside money for the future.