Written by: Corey Janoff
For parents, saving some money for college for their kids is often a financial goal. Everyone has different goals for how much college they want to pay for – some may want to pay for any and all of it, others only a portion. Many of you with children have heard of the 529 college savings plan. Today we want to answer the question, “Is a 529 college savings plan worth it?”
We’ll look at who can contribute to a 529 college savings plan (anyone), along with how to contribute to a 529 college savings plan. We’ll discuss 529 college savings plan contribution limits. Also, 529 college savings plan tax deductions and benefits. Ultimately it will be up to you to determine if a 529 college savings plan is worth it for your particular circumstances.
What is a 529 College Savings Plan?
The modern-day 529 college savings plan was first introduced in the late 1990s at the state level and has since expanded to all 50 states and is federally recognized. In short, 529 plans are a tax-favorable way to save and invest in college.
You can pick mutual funds to invest in within your 529 plan from a menu, similar to the setup in most 401k and 403b accounts. There is a mix of age-based options and mutual funds that invest in specific asset classes, such as US stocks, international stocks, bonds, etc.
There is no national 529 plan. Rather, each state has its own 529 plan (some states have adopted another state’s plan for their residents). Thus, you can use any state’s 529 plan, even if you don’t reside in that state.
The only reason to use your own state’s 529 plan over another is that some states offer a state tax incentive if you are a resident of that state and use your local state-sponsored 529 college savings plan.
How to Contribute to a 529 College Savings Plan
Anyone can contribute to a 529 college savings plan. This is different from the Coverdell Education Savings Accounts, which have both low income and contribution limits.
Most people set up a 529 college savings account and link a bank account for electronic deposits. Some plans even allow you to share a link with family and friends so they can make electronic contributions to your child’s account as well. This is especially helpful when grandma and grandpa want to put money into your kid’s 529 account for birthdays & holidays.
Many 529 plans still accept checks that can be mailed in.
529 College Savings Plan Limits
There isn’t really a 529 college savings plan annual contribution limit. Unfortunately, people often incorrectly assume the annual gifting limit to avoid filing a gift tax return is the limit on annual 529 plan contributions.
Currently, individuals are allowed to gift up to $15,000/year to another individual without it counting against their lifetime gift exemption. A couple could gift $30,000 ($15k each) to a child without any gift tax implications.
You are more than welcome to contribute more than that to your child’s 529 plan; however, anything above that will need to be documented in your tax return and go against your lifetime gifting exemption (currently over $11 million per person).
This could obviously change in the future as tax laws change, so work with your tax professional to determine the appropriate course of action for your circumstances.
There are two types of contribution “limits” for 529 college savings plans, contribution, and balance limits. In addition, there is an annual limit on state tax deductions for some 529 plans (more on that later), and there is a maximum balance limit.
Each state’s 529 plan has a different limit on how much can be held in the account. This amount adjusts upwards over time for inflation. Once you hit the limit, you don’t have to pull money out of the 529 plan, but you can no longer contribute more to it.
Many 529 plans have a limit above $500,000 currently, so it’s unlikely that many of you will have a balance that exceeds that (unless you’re planning to pay for 100% of private undergrad plus medical school for your child).
529 College Savings Plan Tax Deduction
Contributions to a 529 college savings plan are made on an after-tax basis at the federal level (similar to Roth contributions to an IRA or 401k/403b).
However, some states offer a state tax incentive if you utilize your resident state’s sponsored plan. For example, in Oregon (where I live), we can get a state tax credit of up to $300 per year if we contribute at least a certain amount each year.
Some states make it more straightforward and allow you to deduct up to a certain amount (e.g., $10,000) from your income when filing taxes if you utilize your state-sponsored 529 plan. Of course, you can contribute more than that if you choose, but the excess won’t be tax-deductible at the state level.
Other states, such as Pennsylvania, allow you to deduct contributions to both Pennsylvania AND non-Pennsylvania 529 plans (up to $30k/year as of 2021). This is great if you live in PA and want to use a different state’s 529 plan for some reason (maybe you like the investment choices better in another plan).
If you live in Colorado, contributions to the Colorado 529 plan are fully deductible from your income for state-tax purposes with no limit! Well, you can’t deduct more than your income, so if you earn $300,000 in a year, you could only deduct up to $300,000 of contributions that year.
Every state is different, so check the rules for tax incentives on contributions to your state’s 529 plan. Unfortunately, if your state doesn’t have state income taxes, then there is no available tax to deduct from (a good problem to have, I suppose).
While a little savings on state taxes upfront is nice, the big appeal to 529 plans is the tax-deferred growth and tax-free withdrawals for qualifying educational expenses. Very similar to a Roth IRA in that regard.
Any investment earnings grow tax-deferred as long as the money stays within the 529 account. Contributions plus investment earnings are withdrawn to pay for higher education (college, graduate school, etc.) can be taken out tax-free.
Recent tax changes also allow up to $10,000 per year to be withdrawn tax-free for qualifying K-12 expenses as well.
Some states don’t conform exactly to all the federal rules, so check your state’s 529 plan.
Advantages of a 529 College Savings Plan
The tax incentives of the 529 plans outlined above are the main reason most people use them for college savings. If you are planning to save up ahead of time to pay for your children’s higher education, 529 plans are the most tax-efficient way to do so.
The only way more tax-efficient would be to hire your children at your business if you are self-employed and deposit their wages directly into their 529 college savings account. This would make their earnings a tax-deductible business expense for you (so you get some federal tax deduction). We’re getting a little off track here, though, with that thought.
A fringe benefit is asset protection. Money within the 529 plan is earmarked for the named beneficiary (mostly likely your children). Therefore, in many states, it can be more highly protected in the event of a lawsuit than money in your personal checking account. Consult with an asset protection attorney in your state, though, to learn the specific asset protection laws in your state.
Lastly, you are the account owner, so you ultimately control how the money is used, unlike a UGMA/UTMA custodial account where the money becomes the child’s once the child reaches adulthood.
Disadvantages of a 529 College Savings Plan
The big downside to 529 plans is the taxes paid on non-qualified withdrawals. If money withdrawn from a 529 college savings account is not used for qualifying education expenses, the investment earnings are subject to income taxes plus a 10% penalty—kind of like an early withdrawal from a retirement account.
In this scenario, you would be better off utilizing a taxable investment account and simply paying capital gains taxes on investment earnings (versus income taxes + penalty).
Some 529 plans operate as prepaid tuition plans, limiting the use of the funds to public schools within your state (but maybe you like that strategy). Be sure you know if you’re utilizing a general 529 investment plan or a pre-paid tuition plan. It should be pretty obvious – in one. You invest the money in mutual funds. With the other you purchase tuition credits.
The lack of flexibility as a result of the taxes on non-qualified withdrawals is probably the biggest deterrent.
What if your kid doesn’t go to college? You could use the money for other children, grandchildren, or yourself even. Money is withdrawn from the plan just has to be used for education expenses to avoid paying taxes plus a penalty.
What if they go to a less expensive college than you planned for? Same thing. You can use the excess money for someone else’s education, or pay the taxes, spend the money, and be happy that college was less expensive than you planned for.
What if your kid gets a scholarship and doesn’t need the 529 money? Most 529 plans allow you to withdraw funds equal to the value of the scholarship in this scenario without penalty, which is nice. However, you will still need to pay taxes on the investment earnings.
If my kids get scholarships, I’ll gladly pay the taxes on the money I keep for myself in their 529 plans. I am planning on not seeing a penny of it!
Is a 529 College Savings Plan Worth It?
Ultimately, it’s up to you to decide if a 529 college savings plan is right for you. If you have a goal to pay for some of the college education expenses for your children, with the assumption that your kids will go to college, then a 529 college savings plan can be a great tax-favorable way to accomplish that goal.
If you want more flexibility in how the money can be used in the future, then a more flexible investment account may be more appropriate.
With all accounts that have tax benefits, there are strict rules and limitations. If you prefer flexibility, you give up some tax incentives.
This is information only and should not be construed as individualized advice. Investments involve the risk of loss, including total loss of principal. Consult with your tax professional for tax implications for your circumstances.