529 plans provide a tax-advantaged method to save for your child’s qualified higher education expenses. Proper usage of these plans can provide higher tax-adjusted returns while ensuring you are financially prepared to help your child fulfill their educational goals.
In this article, we explore the basics of 529 plans, along with some of their pros and cons.
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The Basics of a 529 Plan
A 529 plan receives a tax advantage since investment earnings in these plans are not subject to federal income tax and typically not subject to state income tax as long as the funds are used for qualified higher education expenses. 529 plans are created by a state, a state agency or an educational institution and thus are considered “municipal securities” under federal security laws. The Municipal Securities Rulemaking Board (MSRB) provides oversight of brokers, dealers and municipal advisors who participate in the market for 529 college savings plans.
There are two types of 529 plans:
- College Saving Plans – An account owner contributes to the account on behalf of a designated beneficiary. These plans are purchased directly from the agency or state creator of the plan, or through an investment advisor.
- Prepaid Tuition Plans – Tuition credits or certificates are purchased and used in lieu of future tuition or other higher education payments. These plans are purchased directly from the state and are not regulated by the MSRB.
A beneficiary, or the child that will use the funds in the future, must be designated when opening an account. The beneficiary may use funds on qualified higher education expenses at eligible institutions, which include colleges, universities and vocational schools. Tuition, fees, books and even room and boarding expenses are considered qualified education expenses.
Withdrawals from the account can only be made by the account owner. Withdrawals are classified as either a qualified withdrawal or a taxable withdrawal. Qualified withdrawals are those used for qualified higher education expenses and are not taxable but reduce certain higher education–related federal tax credits. Withdrawals are considered taxable if they are paid to a beneficiary due to death or disability, used for attendance at military academies or if the beneficiary receives a scholarship or other nontaxable educational assistance.
529 plans typically have fees associated with them. The sponsor of the plan may charge fees or an advisor that sells you the plan may charge a fee. In addition to these fees, the investment funds within the plan charge fees to manage your investments, and there may be fees if you make too many transactions in and out of certain mutual funds.
529 plan investment options tend to be grouped into either target-date or risk-based investments.
- Target-date investments automatically adjust the asset allocation to match the age of the child. As the child approaches 18, the asset allocation is moved into lower-risk assets such as bonds and cash and away from more volatile investments such as stocks.
- Risk-based investments allow you determine the level of risk you are comfortable with. These types of options include risk profiles such as aggressive, moderate, and conservative. The aggressive profile may include mostly stocks, moderate could include of mix of stocks and bonds, and conservative would include bonds and short-term investments such as money market funds.
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Key Considerations for 529 Plans
As with most investment related subjects, 529 plans have their pros and cons.
Some of the key advantages include:
- Earnings and withdrawals are tax-exempt as long as they are used for qualified purposes.
- There are a variety of investment options to choose from based on target-date or risk-based investments.
- 529 plans have high contribution limits, allowing you to save as much as you would like
Some of the key disadvantages include:
- Your investments in the plan could lose money. Choosing a lower-risk investment fund helps reduce this risk.
- 529 plan assets may impact eligibility for financial aid, Medicaid, and federal tax credits related to education expenses
- There is risk that the government could change the tax status of the plans.
- The state or agency sponsor of the plan could make changes to the plan, such as adding or removing investment options, which might impact an investor’s overall return.
Opening a 529 plan when the child is very young is most beneficial. This provides more time for investments to grow before the child attends college. The average rate of inflation for college tuition and fees has exceeded 3% a year over the past decade. This inflation is a risk that can be mitigated through investing in a 529 plan.
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The Bottom Line
529 plans provide a tax-efficient method of saving for future higher education costs and help mitigate rising inflation of higher education expenses. Although there are cons to a 529 plan, the benefits of tax-exempt investing usually outweigh them.
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