Many an empty-nester saw a child off to school last week, proud and wistful as the car left the driveway or the campus receded in the rearview mirror post-drop-off. Those parents who invested early in a 529 plan probably breathed a little easier than those who did not.
529 plans are fantastic, tax-advantaged vehicles designed specifically for investors helping a child, relative, friend or even themselves save for tuition and expenses related to higher education. Plans are sponsored by states, generally in partnership with a mutual fund company or institute of learning, and usually offer either a number of investment options to choose among or a means of locking in a tuition rate. Anyone can set up a 529 plan for a designated beneficiary, and all withdrawals that go toward “qualified educational expenses” (which include tuition, room and board, books, a computer and peripherals, and even internet access) are exempt from federal and (usually) state taxes.
Current laws place no restrictions on income for contributors and there is no limit to the number of plans you can enter into, though withdrawals above and beyond the costs of those qualified education expenses (or non-qualified withdrawals in general) are subject to federal and state income tax, as well as a 10% penalty.
Even though 529 plans have been around since 1996 (the “529” comes from the relevant section of the Internal Revenue Service’s tax code), a May 2019 Edward Jones survey found that 67% of Americans did not recognize them as a way to save for education. Despite this relative lack of awareness, as of September 2018, people nationwide had invested nearly $329 billion in these potent savings vehicles.
With the average annual cost of tuition, room and board at four-year private colleges continuing to soar (up to $48,510 for the 2018–2019 school year, and considerably more at the most exclusive schools), parents, grandparents and other interested benefactors cannot start saving soon enough.
Two Types of 529 Plans, Equally Tax Exempt
529 plans come in two flavors: Savings plans and prepaid tuition plans—take a look at the table below to see a list of characteristics for each. States have their own unique plans, and are allowed to offer both savings plans and prepaid tuition plans. Many states offer additional tax benefits for residents, but you are not restricted to the plan in your home state. For certain investors, it will be worthwhile to explore plans in other states to find the best fit.
529 College Savings Plans
A good comparison for savings plans is a Roth IRA, to which you contribute after-tax income and then can take tax-free withdrawals from in retirement. A 529 plan operates under the same basic principle (contributions cannot be deducted from your federal taxes), but is solely geared to the costs of college or university or qualified K–12 tuition.
Your 529 will be invested in mutual funds, so your return depends on the performance of the holdings in your portfolio. You’ll have the opportunity to invest in a selection of individual stockA financial instrument giving the holder a proportion of the ownership and earnings of a company., bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. and money market funds. Many plans feature pre-made portfolios, including age-based options that automatically reallocate funds from stock holdings to lower-risk bond and money market funds as the beneficiary gets closer to college age.
Investors have two types of savings plans to choose from. With direct-sold savings plans, investors buy 529s directly from a given state’s plan, are responsible for their own research and pay no sales charges. This type of plan is good for the cost-conscious do-it-yourselfer who doesn’t mind taking the time to research which state’s plan is the best fit and is comfortable choosing among the available investment options.
If you do not wish to pick your own investments, you can go through a broker, who will invest your money for you, but at a price. Broker-sold programs can be subject to fees, sales charges and/or annual distribution fees—all of which can cut into your potential gains.
Whether you buy direct or through a broker, college savings plans may offer in-state tax incentives for residents, although not all states do (we’ll cover state-by-state benefits in an upcoming Adviser Fund Update).
529 Prepaid Tuition Plans
Any college, university, vocational school or other postsecondary education institution is generally eligible to accept payments from prepaid tuition plans. This type of 529 plan enables college savers to buy credits at participating schools to lock in future tuition prices. Most prepaid tuition plans are sponsored by state governments for residents and cover tuition and fees only (books and room and board are excluded). They are typically guaranteed by the state backing them.
With prepaid tuition plans, you are not investing in mutual funds—instead, you are making a bet against rising tuition prices. Depending on the state or plan, there may some flexibility as to where you can apply your credits, but these types of plans are often optimized for in-state school tuition. For out-of-state or private schools, you may find yourself having to make up the difference between the plan’s assigned value and tuition out of pocket (some private schools do participate in prepaid tuition plans, however).
If your beneficiary chooses not to attend college or is not accepted, most states have refund options, or the plan can be transferred to another family member.
It should be noted that many of these plans require you to start investing years before your beneficiary is of college age, and they do not guarantee admission to participating schools. If your beneficiary chooses not to attend college or is not accepted, most states have refund options, or the plan can be transferred to another family member. Prepaid plans can be a good fit for some, but they have more strings attached than savings plans and offer less of an opportunity to grow your investment beyond the cost of in-state college tuition.
It may take a lot of work to find the right college savings investment plan for you and to feel confident in your decision. We recommend consulting with a trusted financial adviser to determine the best fit. We can provide you with advice tailored to your circumstances. Please contact us at (800) 492-6868 to learn more. We are always happy to assist.
Stay tuned for updates in the coming months that delve deeper into individual states’ plans and benefits, and a look at financial aid rules that allow grandparents to put 529 assets to work earlier without impacting their beloved student’s eligibility.
Disclaimer: This material is distributed for informational purposes only. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Our statements and opinions are subject to change at any time, without notice and should be considered only as part of a diversified portfolio. Mutual funds and exchange-traded funds mentioned herein are not necessarily held in client portfolios. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.
You may request a free copy of the firm’s Form ADV Part 2A, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.
Past performance is not an indication of future returns. We do not provide legal or tax advice, nor sell insurance products. Tax, legal and insurance information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice, or as advice on whether to buy or surrender any insurance products. Always consult an attorney or tax professional, or licensed insurance professional regarding your specific legal or tax situation, or insurance needs.
The Barron’s rankings consider factors such as assets under management, revenue produced for the firm, regulatory record, quality of practice and philanthropic work.
Editors at the Financial Times bestowed “elite” status on 300 firms in the U.S., as determined by assets under management, asset growth, longevity, compliance record, industry certifications and online accessibility.
Awards referenced above do not consider client experience and are not indicative of future performance. Adviser Investments does not pay a fee to participate in any of these awards.
The Adviser You Can Talk To Podcast is a trademark of Adviser Investments, LLC. Registration pending.
© 2019 Adviser Investments, LLC. All Rights Reserved.