529s

• 529s
  • 529 eligible expenses
  • Types of 529 Plans
    • Standard
    • Prepaid Trust
  • 529 “Brokers”
  • How much should I save?
  • Other perks of a 529
  • Potential pitfalls of a 529

529s are a tax-advantaged savings tool that allows anyone to save money for current or future education expenses for themselves or for a designated beneficiary. A 529 can be used to pay for college tuition (probably the most common), K-12 education, apprenticeship programs, and sometimes for student loan repayment. A 529 is an investment account that operates similar to a Roth account in the sense that you contribute post-tax dollars and those contributions are allowed to grow tax-free. Assuming the disbursements made from a 529 are made for “qualified education expenses”, then the disbursements are completely exempt from taxation. Therefore, only the initial contributions are taxed. It is very similar to an HSA, except that an HSA allows you to contribute pre-tax dollars.

529 eligible expenses

Qualified 529 expenses include, but are not limited to: tuition and fees, room and board, books, and computers. There are, however, a couple of caveats to 529 expenses:

• Only $10,000 can be used per year to pay for K-12 education expenses
• There is a $10,000 lifetime limit when using a 529 to pay for student loan repayments over a lifetime

Types of 529 Plans

Standard

The “standard” plan is a savings plan. This is where you contribute money and allow it to grow over time, and that money is used to pay for qualified expenses. It is straight-forward and the “safer bet” when considering 529s.

Prepaid Trust

A second type of 529 plan is a prepaid trust, or similarly named (depends on what state you live in). It works differently than a standard 529 savings plan. With a prepaid trust, you pay for future college expenses in today’s dollars. Essentially, you are locking in future expenses and paying for them over the course of X number of payments today. I say “X number of payments” because that is often up to you. For instance, Maryland would allow me to pay all of the predefined cost in one lump sum, or spread the cost over monthly payments for 6 or more years. Obviously, the earlier you invest the money, the lower the cost. These plans are not as common today as they used to be, and only a handful of states offer them. As a result, I will not go too far into the details and allow you to investigate your own state’s offerings. I, personally, did not choose to use this type of plan despite the fact that my state offers it and the total cost is significantly lower than saving for college tuition 18 years out from today. I have no idea what college my child will want to attend when she is at that point in her life. Since the prepaid trust is run by a state, it generally only guarantees full tuition for an in-state school. If your child ends up attending a private or out-of-state public school, then you can still use that money but you may only have saved a portion of the tuition.

529 “Brokers”

Many private institutions, like Vanguard or T Rowe Price, will allow you to set up a 529 with them. Also, many, if not all, states offer their own 529 programs. Just because you use a certain state’s 529 does not mean the money must be used for a school in that state. The dollars in a 529 can be used for any college in any state, private or public. Utah and Ohio are generally considered among the states with the “cheapest” plans in terms of investment costs (I may be leaving out other states so please do your research).

It is advisable that you select a 529 plan based on the following criteria:

• The plan’s total cost
• The investment options and cost of investments in the plan
• Tax savings for contributions
  • Some states offer tax breaks for 529 contributions, if you live in that state and have a 529 with that state. For example, I have a Maryland 529 which allows each contributor to deduct $2,500 of contributions per beneficiary. That means for a Maryland family with 2 children and 2 contributors (e.g. 2 parents), they can deduct $10,000 in AGI ($2,500 per child for each parent). These tax savings may trump any savings you get by using an out-of-state 529 plan with cheaper investment options. There are no federal deductions for contributions to a 529.

How much should I save?

There are countless online calculators that will help you evaluate what your monthly contributions should be assuming a given percentage annual increase in college tuition costs (generally 4% or 5%) and a given investment return rate. Compare that with what portion of education costs you want the 529 to cover and that will give you a rough estimate of how much you should contribute.

Other perks of a 529

• The contribution limits for 529s are very generous. Check with your state laws to see your limits. As of the time of this writing, the annual contribution limits range from $235,000 to $550,000.
• If your child does not choose to attend college or you never find a reason to use the 529 dollars for qualified education expenses, you can simply name a new beneficiary of the 529 and essentially “roll over” the funds to a new family member or friend. That would make you a very good friend.
  • Having a 529 impacts a student’s ability to qualify for financial aid, but less than other accounts. Furthermore, if the beneficiary of the 529 is listed as the parent of the student, then it’s impact on qualifying for financial aid will be even less significant.

Potential pitfalls of a 529

• If you use the 529 dollars for non-qualified expenses, then they are taxed as ordinary income and you will pay a 10% penalty
• Funds need to be withdrawn in the year of the expense date, meaning if expenses were incurred in December, they must be withdrawn before January