Parents: Is a 529 College Savings Plan Worth It?
You’ve probably heard about 529 plans and have some general concept of what they are. As a quick refresher, 529 plans are tax-advantaged college savings plans that allow you to invest money for college tuition and other qualified educational expenses. You invest after-tax dollars, which grow tax free and can be withdrawn tax free if used for qualified educational expenses. So the big question is, are 529 plans worth it? Of course, the answer isn’t an easy “yes” or “no.”
The younger your child, the more it makes sense to invest in a 529 plan. That’s because you’ll have many years to harness the power of compounding and investment growth. If your child plans to attend college in say, three years, then there isn’t much time to see noticeable growth.
Let’s run through a few examples and then discuss the key positives and negatives to 529 plans:
Example 1:
Say you invested $5,000 at the start of every year for 18 years with an average return of only 6% per year. You would have invested $90,000 total, but would have ended up with $164,800. That’s a tax-free gain of $74,800! You’ve nearly doubled your money.
Example 2:
Now let’s say you invested that whole $90,000 all at once and let it grow for 18 years with an average return of only 6% per year. You would have ended up with $256,891. That’s a tax-free gain of $166,891! You’ve nearly tripled your money.
Example 3:
Lastly, let’s say you invested $90,000 all at once and let it grow for only 3 years with an average return of 6% per year. You would end up with $107,191. That’s a tax-free gain of only $17,191.
*Keep in mind that these examples are a slight over simplification, because they assume you won’t be invested or accruing any interest throughout the duration of college education.
As you see, the sooner you start investing, the larger amount of tax-free earnings you’ll have.
Now for some general positives and negatives:
529 Plan Positives:
Investment earnings (interest, dividends) and growth are tax-free.
$10k can be used for K-12 tuition each year.
Can rollover up to $35,000 of unspent funds into a Roth IRA account. The account must be at least 15 years old to qualify. (Other limitations apply, and cannot necessarily rollover $35k at once.)
Can change beneficiary to another child, grandchild, or family member.
Can front load 5 years’ worth of contributions without triggering federal gift tax.
That's $180k upfront in 2024.
Many states offer a state income tax deduction or tax credit for contributions, but not all do.
For example, California residents don’t receive any tax incentive for contributing to California’s 529 plan or any other state’s 529 plan.
529 Plan Negatives:
Not as much investment freedom, but most 529 plans offer core index funds.
The earnings portion of a nonqualified withdrawal is subject to state and federal income taxation and an additional 10% federal penalty tax.
Non-qualified withdrawals may also be subject to an additional state tax or penalty. For instance, California imposes a 2.5% penalty tax.
Your child (or other beneficiary) might not use all or any of the funds. This leaves you with extra planning.
Unlike a Roth IRA where you’re able to withdraw your contributions first, any withdrawal you make will include a pro rata amount of your earnings. Meaning, any nonqualified distribution you make will be subject to some amount of tax and penalty.
Final Thought:
It’s impossible to know what the future will hold. I mean, it could be that one of your kids becomes a multi-million dollar entrepreneur who drops out of college (or never even enrolls). If you want to hedge your bets, it could make sense to put some money away into a 529 plan and invest the rest elsewhere. Although you can’t predict the future, having a plan will allow you to confidently maneuver through whatever life throws your way.
Does a 529 plan make sense for you and your family? Schedule a complimentary intro call to learn more.
