Happy 529 Day!
There are a lot of random “holidays” today that I don’t remember ever seeing as a child. We celebrate Houseplant Appreciation Day and World Introvert Day in January. February has Feed the Birds Day and Tell a Fairy Tale Day. My personal favorite is on October 1st - National Coffee Day!
May has a few of its own quirky holidays (here’s looking at you - May the 4th). But there is one, in particular, that we think is worth celebrating: 529 College Savings Day on May 29th!
A 529 plan is a state-level college savings plan that can be a great way to start saving for our children’s (or grandchildren’s) college expenses! Here are the fundamentals:
Types of plans
Most states offer both a prepaid tuition plan and an investment plan.
A prepaid tuition plan allows you to purchase future college tuition credits at today’s prices. The state invests the funds on your behalf and guarantees that you’ll have the same number of credits no matter how high tuition prices climb.
An investment plan, alternatively, allows you to choose from a menu of investments portfolios ranging from very conservative (i.e. money market) to very aggressive (i.e. international or emerging market stocks). Because you’re bearing the investment risk, you also get to keep all the growth. Generally, with enough time, a prudently constructed investment strategy will outperform most alternatives including a prepaid tuition plan (but it’s not guaranteed).
The tax benefits
The primary benefit of 529 plans are the tax benefits, which are similar to those of a Roth IRA. Contributions are made after-tax (meaning no federal income tax deductions) and grow tax-deferred while invested in the plan. Here’s the best part - all of the earnings and growth are income tax-free so long as withdrawals are used for qualifying educational expenses.
Even though we don’t get a federal income tax deduction for contributions, most states (but not all) offer a state income tax deduction. For example, Virginia (where OLIO Financial Planning is located) offers a $4,000 state income tax deduction per year per beneficiary (meaning that, in Virginia, a married couple can EACH contribute and deduct $4,000 for a total of $8,000/child per year). If, for example, a family with two children contributes $4,000 to each of their children’s 529 plans, they would save $460 in state taxes.
The tax-deferred growth is a powerful benefit in itself. It means, in practice, that the taxes you would normally pay on things like dividends, interest, and capital gains remain invested and growing & compounding on your behalf. This can really add up in the long-term! For example, let’s say someone opened a 529 plan at their child’s birth with $2,500 and contributed just $100/mo thereafter. At their child’s 18th birthday, they would have $41,058 in their 529 (assuming a 5% annual rate of return) vs. just $34,720 in a taxable account.
529 Plans are flexible
A common concern we hear from clients is not wanting to lock-up funds to just be used for college. Some won’t go to college. Some will pursue a trade. Some get a scholarship.
It is true that 529 plan earnings that are not used for college will be subject to income tax and a 10% penalty. Your contributions will not be taxed unless you took a state income tax deduction. If this is the case, state income taxes will apply (but not federal tax).
Don’t let that scare you though as there’s a few options if your child doesn’t go to college or there’s money left over. You can change the beneficiary to another child or family member. You can withdraw up to $10,000/yr for secondary school tuition and expenses (i.e. parochial school, private high school, etc.).
One of my favorite benefits is that the 529 plan remains the parent’s (or whoever set-up the plan) assets. With other types of savings vehicles, the balance becomes the student’s at 18 (in most states). If that child say “corvette” while the parent says “Cornell,” the corvette wins. But not with a 529 plan. The parent gets to decide how the balances is used, for what, and when.
What can I do today?
There’s an old expression that says, “the best time to plant a tree was 20 years ago. The second best time is today.” Here’s a few ideas on how to get started:
Open a 529 plan - if your state offers an income tax deduction, consider opening a 529 with your own state. Most states will let you open an account with a minimal contribution of just a few hundred dollars (or less).
Set a reminder to include your contributions on your state tax return for the year you made the contribution as most 529 plans don’t send any documentation or reminders.
Set-up an automatic savings plan for $50 or $100 per month.
Review your 529 plan investments to be sure the investment strategy aligns with when your children will attend college. If you need help, review your strategy with your financial advisor or consider switching to the appropriate age-based investment plan.
Encourage family and friends to contribute to your child’s 529 in place of birthday or holiday gifts. Family and friends can contribute directly to a 529 or you can deposit gifts on their behalf.
Remember that the more you save now, the less you or your child will have to borrow later. Now that’s a gift!
Brian Talbott, CFP®, CTFA
Lead Financial Planner