Pros and Cons of a 529 College Savings Plan - District Capital

Pros and Cons of a 529 College Savings Plan

District Capital Management

Pros and Cons of a 529 College Savings Plan

Have you been thinking of saving for your child’s college education? You’ve probably heard of a 529 plan. You may be wondering if that’s the best way to save for college, what the pros and cons of a 529 college savings plan are, and how to choose one. You may have also heard people telling you to use a Roth IRA instead, should you? These are some common questions we get, and in this article, we will give the answers. Plus, read to the end for a word of caution about 529 college savings plan investments.

Question #1: What is a 529 Savings Plan?

A 529 plan is an investment account that you can use to save for your child’s college. You can also use it for certain K-12 expenses. 529 plans are usually sponsored by individual states. If you live in DC, there’s a DC 529 plan, Maryland has their own 529 plan. But does that mean if you open, for example, a California 529 plan, your child must attend college in California? It does not. Your child can attend college anywhere in the US and use their 529 money from any 529 plans by state. So should you choose the plan in the state you currently live in? Not necessarily. We will explain more below about how to choose a 529 plan.

Question #2: What are the advantages of a 529 plan?

Why would you want to save for your child’s college education using a 529 plan?

  1. You can invest your savings or child’s college savings through a 529 plan. That means you can invest it in either stocks or bonds and it can potentially grow, versus just letting it sit in a checking or savings account.
  2. The 529 college savings program can potentially grow tax-free. For example, if you put $10,000 this year in a 529 plan and it grows, for example, to $20,000 over the next 18 years, you don’t have to pay taxes on the $10,000 of growth that you made inside of that 529 plan as long as you use the funds for qualified educational expenses.
  3. In some states, you can deduct your 529 contributions from your state income tax return. This means the contributions are tax deductible in your state. So in other words, you can get a tax benefit from your state when you deduct your contributions, and then you can get a tax benefit from the federal government when you withdraw the growth tax free.

Let’s look at how much tax savings you can generate by saving through a 529 college savings plan. In the graph below (from the Journal Financial Planning), we can see that saving through a 529 savings plan enabled the parents to earn more than $29,000 more in investment earnings, compared to a bank account. This assumes that the parents saved $64,000 and they generated a certain investment return in their 529 savings plan. In addition, the parents generated more than $10,000 in tax savings through the plan, for a total benefit of more than $40,000.

529 College Savings Plan

Source: Journal of Financial Planning

The 529 college savings plan also offers some flexibility.

  • You can use the money not just for tuition, but for other education expenses like room & board, computer, books and school supplies.
  • Can be used for graduate school (in case your child gets a full scholarship for college).
  • You can change the beneficiary. So if your daughter got her scholarship and doesn’t need the money, you can change the beneficiary of the account to your son. If they are both super smart and get scholarships, you can even think about using it for your own graduate or PhD program or saving it for future grandchildren.

Question #3: What are the disadvantages of a 529 college savings plan?

While a 529 savings plan has many great benefits, it also has a few cons to be aware of. Remember when we said that you don’t have to pay taxes on earnings? Well, that’s only true if you use it for education.

So if your only child decides not to go to college, then when you have to take out the money that you saved in a 529 college savings plan, you have to pay federal and state taxes on the earnings in addition to a 10% penalty for withdrawing the money for expenses other than education. So if for some reason, you wake up one day and you say, “You know what? That $50,000 that I saved in my 529 plan I’m just going to take it out and buy a Tesla. I feel like doing that.” You’re going to have to pay that 10% withdrawal penalty plus taxes, because you’re not using it for education.

However, there are a few exceptions to the penalty. If your child gets a full college scholarship or attends a US Military Academy for example, the 10% penalty for withdrawing the funds is waived.

Question #4: Where should you open a 529 plan?

The answer to this question really depends. If you live in a state that offers tax deductible benefits, and the investment options of that college 529 plan are really good, then you might consider contributing to your state’s 529 plan. For example, if you live in DC, Virginia, Maryland, or Colorado, your 529 contributions are tax-deductible.

In terms of fund fees, the 529 Maryland investment funds range from 0.06% to 0.55% in fees. The 529 VA (Virginia) funds range from 0.09% to 0.72%. The 529 DC funds range from 0.15% to 0.74%. The lower the fees, you get to keep more of your money.

If you live in a state that offers no tax-deductible benefits (such as California), or if your state offers tax incentives but the fund options are not good, you can shop around among other 529 plans. And this is really where a financial planner can be of assistance.

Question #5: 529 vs Roth IRA, which is better?

Some families, including a few of our clients, hesitate to contribute to a 529. They’re worried that maybe their child won’t go to college,  they’ll end up paying taxes and a 10% withdrawal penalty on the 529 plan. Some of them might have a spouse that is a UK citizen and college in Europe might be cheaper than college in the US. In this case, there is an advanced alternative that some financial advisors might have you consider. This alternative is to contribute to a Roth IRA for your child’s education. If you do that, you can take out your contributions, not earnings, but your contributions, without any tax implications or without any penalty.

Here are some considerations on 529 vs Roth IRA. If you’re eligible for a Roth and you have limited funds, Roth has a very attractive feature for the same reason that I just mentioned. You can take out your contributions at any point in time and you can use it for college. Alternatively, if you change your mind, or don’t need the money for college, you can designate it for your retirement.

The main thing that you have to think about is there are no ready-made portfolios like that in 529. You have to know how to invest those Roth IRA contributions if you’re earmarking them for a child’s college. The other major consideration is if you are using a retirement fund, like a Roth IRA, to pay for your child’s education, will you have enough for yourself to retire on? You can’t add more to a Roth IRA than the annual max ($6,000 in 2021) regardless of what you intend to use the money for. So if you don’t have enough other funds that are earmarked for retirement, you might not want to consider this option.

If you can potentially do both 529 and Roth IRA, why not do both? You can contribute to a Roth IRA, get the benefits from that. Then contribute to a 529 and get the benefits from that too. The worst case scenario with your 529 savings is you can’t use it for your child’s college education for some reason and you have to pay taxes on the earnings. As mentioned above, there are exceptions to the 10% penalty. If an exception applies, taking money out of the 529 is not unlike taking money out of any other tax-deferred account, like a 401(k). You defer the taxes until you withdraw, then you pay them. No harm done.

That’s it! Those are the main considerations when deciding whether to invest in a 529 plan to fund your child’s education. I told you at the beginning I would have a word of caution for you though. Here it is: if you’re contributing to a 529 plan, there’s an option to choose target date portfolios based on your son or your daughter’s age. For example, if your child is going to college by 2038, then there is a 2038 portfolio that you can choose as your investment option for the 529 contributions. Sounds easy, right?

I caution you to be careful, because in some cases, not all, the investments in these funds might be too aggressive based on your circumstances. If your child is only three to four years away from college, some target date 529 portfolios still have that specific target date portfolio invested in 40% stocks. Generally, if you’re going to need the money in three to four years, 40% stocks might be too much money in a very volatile investment. Ask your financial advisor for their recommendations on 529 investment options.

Need help with deciding on your 529 plan?

A fiduciary financial advisor can help you decide whether setting up a 529 college savings plan is right for you. The financial advisor can help determine which 529 plan would be best to use, and which combination of 529 college funds are most attractive. A fiduciary financial advisor can also run the numbers, so you know how much you need to contribute each month, so your daughter or son can go to the college of her or his choice.

Schedule a FREE 30 minute discovery call with one of our financial planners, to help you plan for your child’s dream college today!

Best Financial Planner Washington DC

Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help middle-class professionals achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.

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