If you’re interested in this you’re probably a parent and looking to save for your kid’s future college fund and heard that a 529 is a great way to do it. That’s awesome and from what I can tell mostly true. Given how fast higher education costs are growing planning ahead is a good thing, but is it always the right time? Let’s dig in a bit more.
Should I open a 529?
First thing we need to look at is if the 529 is actually the right thing vehicle for you at this point. Generally speaking I’d consider the 529 after you’ve started contributing pretty heavily to (and hopefully are close to maxing out) your own retirement savings accounts (401k/IRAs as I’ve discussed before).
If the above isn’t true, I’d suggest starting with the more traditional retirement vehicles. Both options have similar preferential tax treatment, but the 529 is much more limited in its use.
What exactly is a 529 Plan?
Sweet so assuming you’re setting yourself up for retirement already let’s talk about 529s.
From the SEC’s website
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.
Sounds pretty good. So essentially they are funds, usually run by the State, that grow and can be used tax-free on qualified expenses. Ok, let’s dig in some more on the state funds part.
States and 529s
In general each
state seems to run their own 529s. Note that while each state has their own program you do not generally have to be a resident of that state to use their program. For example: To participate in the Utah 529 you do not have to live in Utah. Note that some states do offer some tax deductions if you participate in their 529, e.g.
Virginia. In California, they offer no such benefits so I’m free to use any state’s 529 without feeling like I left something on the table.
These programs let you choose from a selection of market funds to create your portfolio. Many have an easy “age based target” set of funds. These funds will usually have a theme (domestic, aggressive, moderate, etc) and will become more conservative as the 529 beneficiary reaches college age. You will generally also have the option to create your own mix of funds (from a limited selection they offer).
Qualified Institute
Awesome so you can grow investments and use the gains tax free for higher education at a qualified institute. Most people think of college when you hear “higher education” and they are probably going to be pretty safe that those are qualified institutes, but 529s are actually a little bit more flexible than that. Qualified institutes could be schools abroad and vocational schools as well.
An eligible educational institution is a school offering higher education beyond high school. It is any college, university, vocational school, or other post secondary educational institution eligible to participate in a student aid program run by the U.S. Department of Education.
This includes most accredited public, nonprofit and privately-owned–for-profit postsecondary institutions.
The best way to check is the ask the school and check online. Do both as some schools may not show up in the list online.
Qualified Expenses
Generally these are any expenses that are required to attend the school. A few examples below:
- First up are any tuitions for the school
- Room and board also count, but it can’t exceed the room and board cost used when calculating financial aid (a.k.a how much the school would charge you for room and board on campus). Best to check with the school to find out the amount if the plan is to live off campus.
- Any required books for courses.
- Computers can be counted as a qualified expense as long as they are mainly used by the beneficiary during years that they are enrolled.
- Computer software is less clear, but if it’s required for class it counts. Pro-tip: check the campus store for education versions as they tend to be much cheaper too.
Not Qualified Expenses
- Transportation (even to/from school)
- Health Insurance (even university insurance)
- Sports or club fees
Flexible Beneficiary System
So…what happens if your student decides, they don’t want to be a student. Does all that money go to waste? Not exactly. The plan is fairly flexible and there are no penalties to changing the beneficiary.
Again…the IRS:
Yes. There are no tax consequences if you change the designated beneficiary to another member of the family. Also, any funds distributed from a 529 plan are not taxable if rolled over to another plan for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family. So, for example, you can roll funds from the 529 for one of your children into a sibling’s plan without penalty.
529 Drawbacks
- Note that 529s can only be used on higher education. You can’t use these funds for a private high school for example.
- If your student qualifies for financial aid 529s can also affect the amount they may get.
- There’s also some minor complexity as to how the 529 disbursements are counts depending on who the account owner is (generally this manifests as parents vs grandparents). More on that in a future post.
- If you take money out of it for a non-qualified expense there’s a 10% penalty on top of the regular income tax.
This is by no means a deep discussion of 529s, but I consider the above a decent starting point to understand how they work and decide if it’s something you should investigate further.
Photo courtesy of my cousin last weekend
