What is a 529 Plan?

Wednesday, July 1, 2020 11:10 AM | Taylor Venanzi

For many new parents, education savings (college savings in particular) is a top priority. With student loans effectively crippling the financial growth of our future leaders, it’s quite obvious why a parent would not want to saddle their children with the burden of increasingly expensive college tuition costs.

It’s almost impossible to bring up college funding without discussing a 529 savings plan. So what exactly are these plans and should you be using them to your advantage?

What is a 529 Plan?

A 529 plan is a tax-advantaged investment vehicle used to save money for college costs and in some cases, K-12 tuition costs. The concept of a 529 plan is simple:

1. You invest money on an after-tax basis into an account.

2. You select investments (typically mutual funds) from a menu of investment options.

3. The invested money grows tax free and is withdrawn tax free if used for qualified education expenses.

Straight forward enough right? While the concept of a 529 plan is straight forward, the intricacies can get tricky.

Pros & Cons

Now that we have the basics down, lets go over a list of the obvious pros and cons of a 529 plan:

Pros:

1. Tax Advantages: Along with the tax free growth of your investment, some states offer a state income tax deduction associated with their state specific plan. For example, if you live in Colorado, every dollar you contribute to Colorado’s state 529 plan can be deducted from your Colorado state income tax return. In some states like Pennsylvania, you can deduct your contributions regardless of which state 529 plan you choose.

2. Transferability: You have the ability to transfer the 529 plan from one family member to another qualifying family member (like a sibling or cousin). For families with multiple children, the ability to change the account owner will help maintain the benefits of multiple 529 plans (even if one child does not use the funds).

3. Goal Specific Savings Plan: Similar to saving for retirement, 529 plans have a way of keeping you on track once you set up automatic investments to them. There is just something about tying your savings to a specific goal (particularly for someone as close to you as a child) that gives you a little extra motivation to keep contributing.

Cons:

1. Limited Investment Menu: 529 plans typically have a rather limited selection of investment options. Limited choices can lead to a lack of diversification and improper asset allocation. In addition, the funds within the accounts can be very expensive. For example, the funds in a 529 plan may have internal expenses of 1% while a comparable fund outside of the account could have expenses under 0.10%.

2. Penalties for Non-Qualifying Expenses: If you use these funds for something other than educational expenses, you owe a 10% penalty and income tax on the gains in the account. For example, if you contributed $50,000 and had $75,000 in the account, you would owe the tax and penalty on $25,000 of earnings! The lack of flexibility in a 529 plan as compared to a taxable investment account is significant.

Is a 529 Right for You?

So, is a 529 plan ultimately right for you? When considering these plans, ask yourself a few questions:

1. Do I need flexibility with this investment? How sure am I that my child will use these funds and how much am I willing to bet on that?

2. How much of a tax benefit will I experience compared to investing in a taxable investment account?

3. Am I OK with the lack of investment options within these plans?

4. If I do go with a 529 plan, how should I structure the ownership and beneficiary to maximize tax benefits and financial aid?

5. What other assets do I have that may ultimately be used to fund educational expenses?

"Taylor Venanzi, CFP provides advisory services through Activate Wealth, LLC, a registered investment adviser providing advisory services in Pennsylvania and in other jurisdictions where exempted. All written content by Taylor Venanzi, CFP on this site is for information purposes only and shall not be directly or indirectly interpreted as a solicitation of investment advisory services."

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