Education is expensive. The cost of going to college has been rising steadily, and will probably continue to do so.
If education is something you care about for your children, the good news is that there’s an investment vehicle designed specifically to help make things easier.
It’s called the 529 plan, and today we’re going to talk about what a 529 plan is and how it could potentially help you pay for college for your kids.
If you’d like to watch a video on this topic, check this out:
The 529 plan
According to Wikipedia, “A 529 plan is a tax-advantaged investment vehicle in the U.S. designed to encourage saving for the future higher education expenses of a designated beneficiary.”
Let’s break down that statement piece by piece.
US only (and state by state)
First, 529 plans are found in the United States, and are actually offered by individual states, each of which provide a different set of terms and benefits. Therefore, to actually find the best plan you’ll need to consider both where you live and compare what your state offers against what an out-of-state plan can give you.
We’ll learn more about some of these differences as we go into the specifics.
Investment vehicle
A 529 plan is an investment vehicle.
An investment vehicle isn’t a specific investment like a stock or bond, but rather an account that you can put money into and then allocate to individual investments. This is very similar to a brokerage account or an IRA.
It’s important to know that there are 2 vastly different types of accounts. The first is called a savings plan, and is what I just described. These are what I would consider true investment vehicles. Depending on the state, the account is administered by various financial institutions, such as Vanguard or Fidelity.
The second is called a prepaid plan, and actually only allows you to allocate money toward buying tuition credit towards specific universities, almost like pre-ordering an education. This is generally for the state school(s) of whichever state is offering the plan.
Higher education expenses
When it comes time to withdraw and spend, the money in a 529 plan can only be used on qualified education expenses without a penalty.
This includes tuition, fees, books, supplies, and equipment required for study at accredited colleges in the US and some foreign ones. It also includes room-and-board or housing costs.
Designated beneficiary
Furthermore, these expenses must be incurred for the designated beneficiary, which is a specific person. This can be your own child, or someone unrelated to you.
There are circumstances where you can change the designated beneficiary. The rules generally only allow for changing the beneficiary to someone else in the immediate family of the current beneficiary.
What that does is allow for the situation where a family has multiple children to send to college. You can start a 529 plan for the first child and use it to help pay their educational expenses. Then afterward, change the beneficiary to your next child, and so forth.
If you try to pay for the education expenses of someone other than the designated beneficiary, you will incur taxes and penalties.
Tax-advantaged
Speaking of taxes, let’s get into the primary reason why you would even consider using a 529 plan in the first place. After all, what’s the point in dealing with all these restrictions?
The big benefit of 529 plans is that they allow for the money you out into a 529 account to grow tax-free. Not only that, but you will still not be taxed when you withdraw that money for a qualified education expense as we discussed earlier.
Depending on your income level and tax bracket, this can be a huge boost to your spending power, or how much education you can afford. Another way to look at it is that you will need to save far less money to still be able to send your kid to college.
Earlier, we talked about penalties if you use the money in a 529 for non-qualified expenses, either because it isn’t for education or it isn’t for the designated beneficiary. The penalty generally means you have to pay the income taxes on the growth of your plan’s investments, plus 10% extra on top of that. Again, this only applies to the earnings that accumulate inside of the 529 plan, not the money you directly contribute to the plan, which is already after-tax money.
A second tax advantage exists for those who live in states with state income taxes. If you choose to use the 529 plan of your state, you can get a tax deduction or credit for contributions up to a certain amount each year. That’s a state tax deduction or credit, not a federal one.
If you live in a state without a state income tax, you don’t get that benefit, unfortunately. Whether or not your state has a state income tax and a 529 plan that offers benefits towards it could be an important factor to consider when choosing the right plan for you.
Summary
So today we looked at several important characteristics that define a 529 plan. To recap, we should now understand the following sentence a lot better: “A 529 plan is a tax-advantaged investment vehicle in the U.S. designed to encourage saving for the future higher education expenses of a designated beneficiary.”
This was just a basic introduction to 529 plans that I hope you found helpful. If you’d like me to dig deeper into how much benefit a 529 plan actually provides, or my thoughts on how to choose the best plan, let me know by leaving a comment.
