I have a confession to make. I have a completely mismanaged 529 plan.
Back in 1998 when I was born, my grandfather opened up a 529 savings plan for me. He contributed a small amount of money before he died a year later in 1999.
Flash forward about 17 years, and when it’s time to go to college, my dad tells me that the small amount of money my grandfather contributed had grown to about $10,000! Since I commuted to an in-state college, that was nearly two years of tuition paid for. Unfortunately, there was just one problem. We couldn’t access any of that money.
You see, my grandfather died intestate, or without a will. I was listed as the beneficiary on the plan, when myself, or my dad, should have been made the owner of the account after he died. Because my grandpa is still listed as the owner, my dad has to jump through a ton of legal hoops to garner access to these funds. Maybe we’ll get it done in 2024. 🥲
The moral of the story? 529 plans are an awesome investment vehicle that can help you grow money for future education expenses. But, they can also be a real headache and potential burden if they are not managed correctly. Plus, putting too much of an emphasis on contributing to a 529 plan can lead you to neglect other more important financial goals. That’s why we’ve created this guide to help you maximize your 529 plan possibilities and successfully prioritize college savings!
What is a 529 Plan?
A 529 plan is a tax advantaged investment vehicle that allows you to save and invest money for future education costs. Many 529 plans are state sponsored, and in some states you can earn a tax deduction for contributing. Simply put, a 529 plan is an account that you can open to fund future educational expenses. You can open this account up for almost anyone, including yourself. The funds inside can be invested so that your contributions grow over time..
When the beneficiary of the 529 plan wants to pursue higher education, this money can be withdrawn tax free for eligible costs. Covered expenses are things like tuition, room and board, books, supplies, and any equipment needed at a post-secondary school. This means these funds can be used for community college, four year degrees, and trade school programs. You can also use these funds for k-12 expenses in amounts of up to $10,000 annually.
Why 529 plans are awesome:
While we once had mixed feelings about 529 savings plans, they recently got some sexy new upgrades!
Here are just a few reasons why you might decide to utilize a 529 to save for education…
1. 529 Plans are Tax Advantaged Accounts
Perhaps one of the best things about using a 529 savings plan is that when you withdraw money for eligible expenses, you do so completely tax free.
It’s very similar to how a Roth IRA works. You pay taxes upfront on the money you contribute, and nothing after that. Both your contributions and any investment growth within the account can be taken out tax free for qualified education expenses.
The money you put into a 529 plan is not tax deductible, so you won’t save on taxes upfront. That being said, in certain states you may receive a healthy tax deduction for your 529 contributions. Double win!
2. You Can Roll Unused Funds Into a Roth IRA
One of the biggest gripes we had in the past about 529 plans is that if you or your child didn’t end up going to college, there wasn’t much you could do with that money aside from switching beneficiaries without getting hit by a major 10% penalty. But things changed thanks to some Secure Act 2.0 changes a few years ago. Now unused funds from 529 plans can be rolled into a Roth IRA for that beneficiary up to $35,000.
However, there are a few caveats you need to watch out for when planning on rolling over these funds:
- The “15 Year Rule” states that you need to have had the 529 account open for 15 years. And in certain instances, you need to keep it open another 15 years after changing the beneficiary.
- The “5 Year Rule” also applies when rolling funds over to a Roth IRA. You can only rollover funds that were deposited into the 529 account 5 years earlier.
- Roth accounts have a strict annual contribution limit, which can not be exceeded even with rollovers from a 529 Plan. So if you need to roll over $20,000 and the annual limit for Roth contributions is $7,000, you’ll need to perform multiple transfers over 3-4 years.
- Just like a normal Roth IRA, the account holder must have earned income. That income must meet or exceeds the rollover/contribution amount.
If you’re confused, that’s OK! This is the newest rule for 529 plans and people are still getting used to all these rules and deciphering the IRS lingo.
3. You Can Use 529 Funds to Pay Student Loans
If you have money in a 529 Savings Plan and you or your beneficiary has already graduated from college, you can use your 529 funds to pay down student loans. However, there is a $10,000 limit for using 529 plan funds to pay down student loans.
4. 529 Plans Can Cover K-12 Costs
If your kids attend private school for K-12, you can also use up to $10,000 per beneficiary towards tuition in certain states. This can be a great way to cut down on private school costs.
However, just remember that the longer you keep your money invested within one of these 529 plans, the more likely it is to grow in a meaningful way. Meaning, you get a better bang for your buck leaving those funds invested for college tuition.
5. Teaches Kids about Investing
Opening and contributing to a 529 savings plan is the perfect opportunity to teach your kids about investing. It helps you discuss topics like compounding returns, the cost of college, tax savings, and the perils of student loan debt.
Plus, you can encourage them to try and save money on college by applying for scholarships and financial aid. Explaining to them that they could roll whatever is left in the plan into a Roth IRA for retirement investing.
If your student were to roll $35,000 of 529 plan money into a Roth IRA between the ages of 22 and 26, that money could be worth $517,487 after 35 years. If that doesn’t motivate someone to apply for scholarships, I don’t know what will!
That being said, 529’s aren’t the only available investing account for kids. It’s important to weigh all your options. The primary intent for the 529 plan is and will always be covering education costs, not retirement investing.
6. High Contribution Limits
Lastly, most 529 plans have relatively high contribution limits. This is great for families that anticipate very high education costs in the future. Limits differ from state to state, ranging between $235,000 to over $550,000.
But, high contribution limits can be a double edged sword. It’s important not to overfund 529 plans, because you can only withdraw the funds for qualified expenses. Remember, only $35,000 worth of unused funds can be rolled into a Roth IRA. And there are plenty of ways to save money on college.
Another thing to watch out for is the annual gift tax exclusion. For all you extremely deep-pocketed parents and grandparents out there (net worth over $10M+) it’s a good idea to consult your tax advisor before dumping huge amounts of money into 529 plans.
Potential Downsides To 529 Plans
Now that you’ve read about all of the awesome benefits of 529 plans, let’s go through potential pitfalls.
1. Neglecting More Important Priorities
You know how on an airplane they tell you to put on your own oxygen mask before helping kids? Well, it’s the same with securing your retirement nest egg. Before starting to fund a 529 savings plan for your kids, secure your own financial future!
Lots of folks start saving for their child’s education before they’ve contributed enough to their own retirement accounts. While it’s a sweet sentiment, this will only end up backfiring in the long run. There are a ton of things kids can do to reduce college expenses. Like, applying for scholarships and financial aid, getting a campus job, or becoming an RA. But the same cannot be said for you and your retirement.
Unfortunately, there are no scholarships for retirement.
We all want to help our kids get ahead financially, but here’s the hard truth… 529’s might be helping your kid in the short term, but if your retirement savings are not sufficient, you might have to depend on them financially later in life! Don’t prioritize college savings until you get into the swing of regularly contributing to and maxing out your retirement accounts. Everyone is better off that way.
Figuring out what order to best tackle your biggest money goals can be confusing. That’s why we created the Money Gears! These can help to provide you with some clarity when it comes to the order of attack.
If you take a look, you’ll notice that saving for your kid’s college falls under money gear 7. That’s after you’ve already fully funded your emergency fund, started investing in tax sheltered retirement accounts, and paid down your major debts.
2. Accidental Overfunding Penalties
Overfunding a 529 plan is more common than you might think. Actually, it’s kind of why they introduced the Roth rollover option recently. Because too many people put money into 529’s and then didn’t end up needing the full amount they had saved.
To access any other funds and spend them on things outside of education costs, you’ll be subject to a 10% federal penalty as well as taxes on any growth within the account. This eats heavily into the growth and interest earned over the years. With such a high penalty, the money would have been better off invested elsewhere, like in a 401k, IRA, or taxable brokerage account.
**There are some ways to skirt the 10% penalty. For example, if your child gets a scholarship, becomes disabled, or attends a US military academy**
3. College Can Be More Affordable
Another downside is that large 529 balances could encourage waste when it comes to college spending. If a kid has a huge college fund that must be spent on education, there’s no real incentive for them to save money.
While it’s great to have money saved up for education, it’s still important to pursue savings through avenues like financial aid and scholarships. Plus, you or your child could choose to go to a more affordable school. Or they could work to help pay for some of the costs. While 529’s are a nice thing to have, it’s definitely not mandatory, and some might even say it’s overrated.
Bonus- This year, we interviewed Jason Brown on the podcast, Author of It Is Possible- How I Earned Two Debt-Free Degrees… and how you can, too. Be sure to check out the episode for even more ways to get through school without taking on debt.
4. Fees and Mismanaging Funds
Just like any other investment account, you could mismanage the funds if you do not invest them properly. Also there’s no real “free” account options like there are with other investment account types. Although small, there are admin fees to consider with each type of 529 plan.
Similar to retirement investing, you can decide whether you want your investments to be aggressive or conservative. When your beneficiary is younger, it may make sense to invest more aggressively. Then as they approach college age, adjust your portfolio to be more conservative. This can help you to grow those funds while also reducing the risk of losing it all right before you need to tap them.
Withdrawal strategies can be tricky to navigate also. Deciding which costs to cover, when to make distributions, and claiming them properly takes a decent amount of planning. If you’re hoping to take advantage of the Roth rollover option, there are a fair amount of hoops and rules to traverse to pull it off!
5. Can Prevent You From Spending on Your Family Now
While it’s great to save money for college, it’s important to also prioritize spending money now. When your kids look back on their childhood they’re more likely to remember time spent together, family vacations, and other enriching activities they participated in.
If investing for college prevents you from creating foundational memories with your kiddo, we would suggest holding off. Instead, work with them to lower college costs when the time comes. Remember that a full ride to college will not make up for missed time and memories made with loved ones.
Alternatives to 529 Savings Plans
While 529 savings plans are a great option (and possibly the best option) for education savings, it’s not the only way to give your kids a financial head start! Here are a few other ways you can help to save for higher education costs.
- 529 Prepaid Tuition Plans: Only 9 states offer 529 prepaid tuition plans, but they are perfect if your kid will 100% attend one of those state schools.
- Roth IRA: Contributions can be withdrawn at any time for any reason, so you potentially use this to save for college. (But, this could screw over your own retirement plans, which defeats the point)
- Target Date Funds in a Brokerage Account: Be aware: If you go this route, you won’t enjoy any of the tax benefits that a 529 plan brings. You may also be subject to capital gains tax.
- Bonds: Some treasury bonds can be redeemed tax free on the federal level for eligible education expenses. The downside here is you probably won’t experience significant growth.
- Getting Creative: A great example is Brandon Turner, who bought a 4-plex when his kid was born and plans to use its cash flow to fund their education.
Remember, saving for your kids’ college isn’t mandatory. You can always help your child navigate student aid, loans, scholarships, or even help them get lucrative work so they can afford to pay for college themselves.
All in all, 529 plans are great. But they are def not the only option for getting your kid through college and having a successful financial life.
Rising Costs of Higher Education
It’s no secret that the rising costs of education have presented a real problem throughout the United States. In 1992-1993, tuition, fees and room and board clocked in at $4,870 for four year public schools and $21,860 annually for private schools adjusted for inflation. But in 2022-2023, the average cost of a four year degree including tuition, fees, and room and board was $23,250 for a public school (in-state), $40,550 for a public school attended by an out of state student, and $53,430 annually for private schools!
As you can see, public school tuition has more than quadrupled in cost, and that is accounting for inflation. Meanwhile the cost for private schools has more than doubled.
How to fight back against education inflation:
But just because colleges continue to raise prices doesn’t mean you need to shell out more and more of your hard earned money. In fact, the best response you can have to these increases is to be more aggressive in your efforts to cut back on the costs of college for you and your loved ones. We’ve covered a number of ways to save on college in this post, but here are just a few tips for saving even more on education:
- Firstly, encourage your kids to attend an in-state college or university. This is potentially the easiest way to cut your college costs by more than half. Plus, state universities often come with lower travel costs, which can further increase your savings.
- If you or your child has their heart set on a private school, consider attending a community college for the first two years, then transferring to a dream school. Your degree will still be from your desired university, but you’ll graduate with far less debt than if you had attended all four years.
- Lastly, be sure to thoroughly explore all financial aid and scholarship opportunities for your prospective student. Fill out the FAFSA as soon as it becomes available, as some of its financial aid is first come first serve. Then, reach out to your student’s counselor, or other local organizations to find out about scholarships you can apply for.
Choosing the Right 529 Plan for You
If you’re sold on opening up a 529 savings plan to invest for education costs, you may be wondering where the best place to open one up will be. There are two options for 529 savings plans: State-sponsored 529s and advisor-sold 529s.
When picking a 529 savings plan, you will want to look for a plan that carries the lowest fees, the best investment performance, and the greatest benefits. Depending on which state you live in, you will have different options available to you. Looking into your state’s sponsored 529 plan is a great place to start, because in about two thirds of states, you can get a state tax break for contributions.
If your state does not offer a tax break, and has relatively high investing fees, you can also consider choosing another state’s 529 plan. Georgia’s 529 savings plan is an excellent choice for many as it has some of the lowest investing fees available.
Different 529 plans also come with varied investment options. As opposed to selecting single stocks, typically you will have just a few choices for your investments. While some offer age based portfolios, which will become more conservative over time as your child approaches college age, others offer “static portfolios,” where you can select a portfolio based on your risk tolerance.
With these, you will have to go in and make changes to your risk level manually. If you want to take a more hands off approach, choosing a 529 plan that offers age-based portfolios could be best for you. Whereas a static portfolio 529 plan can allow you to have more control over how your money is invested.
Who Can Be An Eligible Beneficiary?
A beneficiary is the future student who is supposed to benefit from the 529 plan, and it can be pretty much anyone (even yourself!). The only criteria is that the beneficiary must be a U.S. citizen or resident alien with a Social Security Number or Individual Taxpayer Identification Number.
However, changing a beneficiary on an existing 529 plan has some limitations. A beneficiary can be changed at any time, as long as the new beneficiary is a member of the original beneficiary’s family.
The term “family” covers a very broad range of members though… Sons, daughters, step children or foster kids, brothers, sisters, parents, etc. Here’s a full chart!
Understanding Contribution Limits and Tax Implications
Because each state offers different 529 plans with different tax benefits and contribution limits, you will need to look into the details of each state specific plan to fully understand the tax implications of your 529 savings plan. While all plans allow you to withdraw earnings tax free for qualified expenses, only some will allow you to deduct contributions when filing your state taxes.
We suggest calling the customer support number to make sure you fully understand the nuances of your specific account.
It’s also important to note that having a 529 savings plan can affect a student’s eligibility for need based student aid applied for using FAFSA. The College Investor covers this in great detail in their “How Does A 529 Plan Affect Your Financial Aid and FAFSA” post. Be sure to read it post before deciding how to manage your 529 plan funds.
Funding Options for 529 Plans
To make the most of 529 plans, it’s best to contribute to them as early as you can. Keeping the money invested for longer means that compound interest will have more time to work its magic. This will ensure the balance grows more over time. Here are two different strategies you can use to contribute and invest in your 529 plan.
1. Front Load Your Contributions
Many 529 plans allow you to contribute the gift tax limits for five years all at one time. This can also be referred to as “superfunding”a 529 savings plan.
One of the best benefits of this strategy is that by lumping all of those funds in within the same year, more money will remain invested for longer. By the time college bills come around it will have the biggest opportunity for compounding.
2. Slow & Steady
If you don’t have a lump sum to contribute to a 529 plan, don’t worry! You can still grow this account significantly over time with small, consistent contributions. For example, if you opened up a 529 plan for your child when they were born and contributed just $100 each month, by the time your child turns 18 they could have $46,864 in their 529 account assuming an 8% return on investment. That’s a lot of money!
If you don’t currently have money to contribute, try making some adjustments to your budget. Maybe you can negotiating your bills to free up a few extra dollars each month. Even just canceling a few subscriptions or using one of these Ways to Save an Extra $100 Per Month can help you to reach your 529 savings goals.
Direct-sold vs. Advisor-sold 529 plans:
Just like the names sound, you can directly manage your 529 plan investments yourself or solicit the help of a financial advisor.
The problem with advisors-sold plans (or really any managed investment account) is that brokerage firms take a HUGE chunk of commissions and fees for doing relatively little work.
Investing fees are usually disguised as tiny percentage that seem really small. People ignore it because they think, ‘how harmless could a little 1.5% fee be!?’ Well… after compounding for years on end, a lot. Those fees take massive cuts from your investments! Here’s a visual example of the total fees after 18 years of compounding and contributing $2000 a year to a 529 plan…
A tiny investment fee could add up to well over $10,000 that stays in your account over time. Wouldn’t you rather that money go towards your kids’ education? Of course you would! It’s definitely worth learning to manage your own account and opting for a direct-sold 529 plan.
Learning to invest isn’t as hard as people think – and it’s 100x easier these days than it was 20 or 30 years ago!
Investing Inside a 529 Plan
First, if you’re new to investing, check out this beginners guide to cover all the basics. The more you learn, the more confident you will be to manage your own direct 529 account.
One of the rookie mistakes we see with investment accounts is contributing money and forgetting to actually go in and invest it! Make sure not to forget this crucial step when funding a 529 plan.
When investing within your 529 plan, you’ll have different options depending on which plan you choose. However, most 529 plans offer a mix of age based and static investment options as discussed previously.
Age based investment options will start off higher risk as you are farther away from needing those funds, and will slowly become lower risk overtime as you approach your target date. On the other hand, static investments allow you to choose your level of risk. As you approach needing to use those funds, you may want to switch over to a more conservative investment mix . This will mitigate the possibility of losing a large amount of money just before you need it for education costs.
Managing your 529 Plan Account
When it comes time to withdraw the money from your 529 plan, you need to be strategic. Mishandling 529 funds can cause you to get hit with significant penalties. So make sure to take extra care before drawing down on those funds.
Remember that withdrawals will only be tax free and penalty free for qualified education expenses. Withdrawing money for other things will cost you.
Some good news though – If you accidently withdraw too much from your 529, you have 60 days to put the money back without penalties. It’s important to act fast if you make a mistake.
Again, you can withdraw 529 funds tax free to cover expenses like tuition and fees, room and board, books, supplies, computers, and any necessary equipment required for your degree of study. You can also withdraw funds to pay a portion of your student loans up to $10,000.
If the original beneficiary decides they do not want to pursue higher education, you can always change the beneficiary. Even if you don’t have any other children in your life, you could change it to yourself and pursue higher education or career development. Often, parents will use a single 529 plan account to save for multiple children. When they are done paying for one child’s college, they will change the beneficiary to the younger child.
Estate Planning and 529 Plans
So what about my little snafu I mentioned at the beginning of this article? How can mishaps be avoided if the owner of a 529 account dies?
The answer in many cases is to name a successor owner. This is the person who will assume ownership of your account should you die, and will allow transfer of ownership without entering probate. Luckily, in most instances a 529 plan is not a part of the deceased’s taxable estate!
The Bottom Line:
There are many ways to save for higher education, and a 529 savings plan is among the most desirable options. Although contributing to a 529 savings plan can be a great way to fund an education, when mismanaged or poorly planned, these investment tools can lose some of the perks that set them above the rest.
If you’re planning to start a 529 plan, take the time to look over the ins and outs of all available plan options. Research upfront makes a huge difference in maximizing the account benefits and making college more affordable for your future student.
Related Posts:
Excellent article 💯.