Saving for college has become an increasingly important goal for many families. The cost of higher education continues to rise, and parents are seeking ways to alleviate the financial burden on their children. One popular option is the 529 college savings plan. But are these plans truly worth the investment?
Understanding 529 College Savings Plans
Before we get into a verdict for the 529 college savings plan, let us first dive into what they are. 529 plans are state-sponsored savings accounts specifically created to assist individuals and families in saving for qualified higher education expenses. These plans come with unique education-focused benefits, as well as state-specific advantages provided by the sponsoring state. It's worth noting that residency in the state is not a requirement to invest in their 529 plans. However, in such cases, you won't have access to the state-specific benefits they offer. These can be quite advantageous depending on the state. Here is a common list of state-specific benefits:
- State Income Tax Deductions: Many states offer state income tax deductions or credits to residents who contribute to their state's 529 plan
- Matching Grants: Some states offer matching grant programs, where they will match a portion of the contributions made to a 529 plan, particularly for lower-income families.
- Scholarship Opportunities: A few states provide scholarship opportunities exclusively for residents who use the in-state 529 plan. These scholarships can help reduce the overall cost of education.
- Lower Fees: Residents may benefit from lower administrative and management fees when they invest in their state's 529 plan.
- In-State Tuition Guarantee: In some cases, contributing to an in-state 529 plan can provide a guarantee or preference for in-state tuition rates at public colleges and universities.
- Protection from Creditors: In certain states, the funds held in 529 plans are protected from creditors, providing an added layer of security for your college savings.
Types of 529 Plans
The type of 529 plan can determine how the "education-focused benefit" works. 529 plans come in two primary forms: prepaid tuition plans and education savings plans.
Prepaid Tuition Plans
Prepaid tuition plans allow you to purchase future college tuition at today's prices.
- How They Work: You make contributions in return for "credits", and the state guarantees that the credits (plan's value) will increase with tuition inflation. When your child goes to college, the plan covers tuition and sometimes other mandatory fees at in-state public institutions.
- Example: If you buy one year's worth of tuition credits today, it should cover one year of tuition in the future, even if tuition costs have increased significantly.
Education Savings Plans
Education savings plans are investment accounts where you contribute money that is then invested in various assets, such as stocks, bonds, or mutual funds.
- How They Work: Your contributions goes towards the plan's underlying investments and it grows over time. You can use the funds tax-free for a broader range of qualified education expenses, including tuition, room and board, books, and sometimes even K-12 education.
- Example: If you contribute regularly to an education savings plan, your savings can grow based on the performance of your investments. You have more flexibility in choosing where to use the funds, including out-of-state or private institutions.
Prepaid Tuition Plans vs Education Savings Plans
Prepaid tuition plans and education savings plans offer distinct benefits so it's important to consider their pros/cons carefully to see which ones works better for you.
Prepaid Tuition Plans
- Price Certainty: You lock in today's tuition rates, ensuring that your child's future education costs are known in advance, protecting against tuition inflation.
- Simplicity: These plans are straightforward, as you're essentially buying tuition credits for a specific period, making them easy to understand and use.
- Ideal for Public In-State Institutions: Prepaid plans are a good choice if you're confident that your child will attend an in-state, public college or university.
- Limited Usage: Prepaid plans are typically designed for in-state, public institutions. They may not cover other expenses like room and board or out-of-state or private school tuition.
Education Savings Plans
- Flexibility: Education savings plans allow for a broader range of qualified expenses, including tuition, room and board, books, and K-12 education in some cases.
- Investment Potential: Your contributions can grow over time based on the performance of your investments, potentially providing higher returns.
- Choice of Institution: Education savings plans aren't limited to in-state, public institutions, making them suitable for any college or university.
- Out-of-State and Private Schools: They are useful if you're considering out-of-state or private colleges, which prepaid plans often don't cover.
- Market Risk: Education savings plans are subject to market fluctuations, and there's no guarantee of specific returns, so there's potential for loss.
- Complexity: They require more active management and decision-making, which may not be ideal for everyone.
- Limited Investment Options: Unlike brokerage accounts, you don't have as much control over what the education savings plan is invested in. Education savings plans is typically setup with some sort of managed fund with preset investments. And unfortunately, a majority of them are pretty conservative so it can be difficult to find one that does something standard like the S&P500. This means that can further limit the upside vs a prepaid tuition plan.
Choosing One Over the Other
Prepaid Tuition Plans are typically recommended if you're certain your child will attend an in-state, public college and want to lock in today's tuition rates for cost predictability. Education Savings Plans are typically recommended if you want more flexibility, including the option to use the funds for various education expenses or if you're considering out-of-state or private institutions. Education savings plans are also more suitable if you're comfortable with some degree of investment risk.
Are There Contribution Limits for 529 Plans?
Yes, there are contribution limits associated with 529 plans. These limits are set by the Internal Revenue Service (IRS) and are intended to encourage individuals to save for educational expenses, while still providing flexibility. There are two main types of contribution limits:
- Annual Contribution Limits: Each year, you can contribute a certain maximum amount to a 529 plan without incurring federal gift tax. The annual gift tax exclusion is different for single filers than for married couples filing jointly.
- Lifetime Contribution Limits: In addition to the annual limits, 529 plans often have lifetime contribution limits. These limits vary by state but are usually quite high, typically in the hundreds of thousands of dollars or more. Once the total balance in a 529 plan reaches the state's lifetime limit, you can no longer make contributions to that plan.
529 plans can be helpful for those who want to be better prepare for their child's education. However, it's not an easy decision and requires careful research and consideration. In some cases, people may prefer to not go with a 529 plan at all and go with a classic brokerage account instead due to the better risk/reward options over a longer term.
For me, I decided to give 529 plans a try. I split my "future child education expenses" into an education savings plan and a classic brokerage account. I decided to go with an education savings plan over a prepaid tuition plan to give my future child the most flexibility for their educational journey (since prepaid locks you down quite hard).
For the education savings plan, I went with the UNIQUE College Investing Plan (sponsored by the state of New Hampshire) offered by Fidelity. The reason I went for this specific plan is two-fold:
- I live in WA and it has no income tax, meaning I don't really get much benefits from going for a state sponsored plan.
- 529 plans have very limited investment options. The UNIQUE College Investing Plan gave the most flexibility in terms of what I could invest in.
I started investing in the education savings plan regularly since early 2022 (so about two years now). Comparing the results today, it stays about 1-4% return during poor market performance and about 5-10% return during good market performance. Meanwhile, my brokerage account is performing above that on average. There's a lot of factors at play here but I want to say two years is still to early to tell which one is better. One thing to note is that my brokerage account more susceptible to tax code changes more so than my 529 plan (since capital gain taxes get modified more often historically than features of the 529 plan) so I have a bit more peace of mind in that regard. I will post a year end update on my 529 plan and also share my investments in a future post. Cheers.
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