The subject of the 529 comes up a lot. It is a tax-advantaged way to invest with your child’s education being the sole focus. However, there is a good case to be made for skipping the 529 altogether and making your investments for the kiddos mirror your current investment strategy. Of course, if you are a “fire and forget” investor and simplicity is your biggest consideration, then a 529 is probably just the ticket for you.
What is a 529?
As stated before, the 529 is a tax-advantaged investing/savings vehicle that is used to pay for college, high school, or vocational education for dependents. The investor (you) is able to select a beneficiary (in most cases, your child) and can change that beneficiary once a year to another eligible beneficiary (see the investopedia.com article below for more on that). Even though it is named for a section of the Federal Tax Code, 529’s are offered from each of the 50 states, subject to state law, and those laws vary from state to state.
The Two Options
When you open a 529 you have two options:
- A 529 Savings Plan (most common)
- Prepaid Tuition
The Savings Plan
The savings plan works very similarly to a Traditional IRA. The contributions are tax-deferred until they are withdrawn, and can be used for “qualified educational expenses”.
Prepaid Tuition
The Prepaid Tuition option is more like a futures contract. For this option to make sense, you need to know which institution your child will be attending. The benefit here is that colleges and private schools typically raise tuition every year, so with the 529 you can lock in the tuition rate of the current year and as long as the tuition is higher when the child attends, you win. The downside here should be obvious: if your child decides not to attend the institution you picked for them, you will be subject to penalties when you go to withdraw your money, but kids never do stuff like that.
The Tax Advantages
We’ve already mentioned the tax-deferral for 529 contributions, but there are also a few others.
- In some states, for college tuition, withdrawals are tax deductible for state income taxes, 529 withdrawals are not tax-deductible for federal income taxes.
- For K-12, the same applies.
- For “qualified education expenses”, withdrawals are tax-exempt
- For K-12, the same applies, but there is currently a $10,000 limit
Remember that for any tax deductions to take effect, you must be enrolled in your state of residence’s 529 plan.
So Why Wouldn’t You Want a 529?
Like we said, for the “fire and forget” investor, the 529 is probably the way to go. However, if you take an active interest in your portfolio, the 529 might not be the best plan. Here’s why.
The 529’s are different for each state, but in general what is offered is a collection of mutual funds that will either track, or slightly under-perform against the market as a whole. They might also be life-cycle funds, which automatically reduce their stock exposure as the target date approaches. Funds that track the market are fine, and if that’s what you were going to put your kid’s college fund in anyway, then the 529 becomes obvious. However, if you are searching for more aggressive investments, or if you simply want more flexibility, then mirroring your own portfolio may be the way to go. Remember that the government’s Thrift Savings Plan, with all its tax benefits, can be wholly beaten by a rate of return less than 1.0% greater over 30 years. There is also the obvious risk that your child receives a scholarship and does not need tuition paid for, or they might not go to college at all. In those cases, in order to get your money back, you must pay all the taxes you owe, and a 10% penalty.
Conclusion
For most of us, the 529 is certainly worth considering. There are risks involved in both strategies, but for most people those risks will not materialize. Either way, if your intention is to reduce your financial burden during those college years, better to start now rather than later. (And yes, you can open a 529 for unborn children).
The Investment Club 