The 529 savings plan for college, should you invest?

Many of our friends, including us, have one, two, and in some cases, 3 children at this point in life. Seems like only yesterday we were taking shots of tequila at our house for taco tuesdays and staying up until 4am listening to some of the best DJ’s in the world right here in our very own city. Now our conversations sound like this: “so are you investing in a  529 plan for your kid?”. The short answer is no, and for multiple reasons.

What is a 529 Plan?

Better known as a “Qualified Tuition Plan”, in 1996 Congress created these savings plans as a way for people to stash some hard earned money away in a tax-advantaged account known as a 529 plan.

A 529 plan is operated by an individual state or education institution, in which you can setup a beneficiary for the account, such as a child or grandchild. The funds in this account can only be used for education purposes, such as tuition, room & board, fees, books, and just recently; computer technology.

There are two types of 529 plans, prepaid tuition plans, and savings plans. The prepaid tuition plan locks in the tuition price at public and private institutions, like buying credits for units. This one is a bit more confusing than the typical 529 savings plan, which is what most people do. With the savings plan there is no lock on price of tuition, but it does cover a much wider variety of expenses than the prepaid tuition plan.

What are the advantages of a 529 plan?

According to IRS.gov, “Earnings are not subject to Federal tax and generally not subject to state tax when used for the qualified educational expenses of the designated beneficiary”. 

There is some key wording in this quote: earnings are not subject to Federal tax, meaning, your contributions to this account do not lower your taxable income. You will not have to pay tax on the growth of your money, as long as it’s used for the proper expenses.

According to the SEC, “Just a few states allow residents to deduct contributions to any 529 plan from state income tax returns”.

Like I said earlier, each state offers a 529 plan, and I believe most of them do not require you to be a resident of that state to invest in their plan. This means you could live in CA, invest in a fund in AZ, and your kid could go to school in NY and use the funds in the 529. So shop around (and watch the fees), each state is different.

You do have the ability to change the beneficiary of the plan to another family member without any tax consequences. You can also roll over funds from one child to another child within the family without any consequences.

Lets say for instance, Bobby went to college and it cost $40k total. His 529 plan had $45k saved up. He would be able to roll it over to his little brother’s 529 plan without any tax consequences. What nice brother!

Now take this into consideration, if you do end up using any of the funds in the account for something other than the expenses outlined above, you will be subject to income tax on the money, as well as a 10% additional Federal tax. Ouch!

Why I don’t like 529 plans, and will never contribute to one.

Now, you’re probably thinking “what about your child’s education?”. Yes, I do agree education is a big expense and there will come a time when I need to cough up a decent amount of coin to send Isabelle to school. However, a 529 plan is not the bees neez when it comes to savings.

A lot of these plans offer a wide variety of actively managed funds with high fees, and few index funds worth putting my money into for purposes of growth. Sure they beat your savings account down at Wells Fargo, but why contribute to something good when you can contribute to something great?

I actually have a few ideas of how to pay for Isabelle’s education by investing money with tax free growth through our 401k’s and IRA’s in the meantime. Then once we retire and move into a much lower tax bracket (hopefully 0%, thanks Jeremy!) we can start a roth IRA conversion ladder and make withdrawals from that account tax free. So that money will have grown tax free, and withdrawn tax free. How’s that for a savings plan? We are hoping to retire by the time she turns 18. If she decides to go to college right after high school, we will be prepared to support her along the way.

By doing this, I can pay for anything Isabelle needs for school. Not just what the 529 plan says I can pay for. I like having complete control over my money and how I spend it.  Why doesn’t a 529 plan cover transportation costs like bus passes and train passes?

Conclusion:

Saving for college is something I highly recommend getting a head start on early in your child’s life. A 529 plan can be a helpful tool for some, but it’s not a right fit for everyone. For us, it just doesn’t feel right. I have other ideas of how to save in tax advantaged accounts for my child’s educational purposes. Just not a 529 plan. I highly recommend reading the IRS website  for more information (cause that’s always fun!), as well as the SEC website.