What Is A 529 Plan (And Should I Have One)?
When I was asked to research and write a post about 529 plans, I had one question: “A what now?”
Seriously. I had never heard of these before, and I’m about to start my third year of college. I would be unsurprised if you haven’t heard of them, either. A 529 plan is something that you usually learn about from a financial advisor. But if you’re like me (and most people for that matter), you don’t have one of those.
So let’s see if we can fill in some of those gaps in our knowledge.
What is a 529?
Qualified Tuition Programs, as they are formally known, are authorized by section 529 of the Internal Revenue Code… hence the pithy nickname. In short, they’re tax-free programs designed to help students (or their parents) save up for college.
In practice, a 529 works much like an ordinary savings or investment account. You deposit money in regular installments into the account to be used for college expenses months or years down the road. The plan is controlled by whoever sets it up and withdrawn by the named beneficiary of the account. And, yes, if you’re 18 or older, these can both be you.
The programs are managed and distributed by U.S. state governments, and they come in two basic flavors: prepaid tuition plans and savings plans.
The Prepaid Tuition Plan
There are currently 18 states offering some form of prepaid tuition, though only 11 were accepting new applications as of 2018. These plans allow you to pre-pay (shocked gasp) for future college tuition and fees. This type of plan works best when it is set up years in advance of attending college, so it’s aimed toward parents looking to save while their children are young. While a prepaid plan will gain a small amount of interest, that isn’t the main goal here. Instead, prepaid tuition allows you to lock down the price of tuition at a certain school. This can be a massive benefit, considering how quickly tuition rates have been rising. (For reference, College Board reports that from 2008 to 2018, the average tuition price for a public 4-year college increased by around $270 per year. That’s an increase of 3.1%, compared to only a 0.8% increase in median family income over the same period. Yikes!)
It is worth pointing out that this security comes at the cost of flexibility. Most prepaid tuition plans require you to live in the same state that offers them, and many will only be accepted at certain schools. Others may have grade requirements or restrictions on the age of beneficiaries, and all have specific enrollment periods. And, as the name implies, prepaid tuition plans only pay for tuition and college fees, not for books or other supplies needed for school.
The Savings Plan
This type of 529 plan is more common; all 50 states (and DC) offer at least one. A 529 savings plan is a mutual fund which collects returns on investments until withdrawn. These are typically a bit more flexible than the prepaid plans. Very few have residency requirements, and a 529 savings plan can be used on more than just tuition. Any qualified school expense can be paid for with a 529 without the disbursement being taxed.
It should be noted, however, that a 529 savings plan is still an investment account, and therefore still carries some risks. When you open one, you are entrusting your money to the state which then invests it on your behalf. Unfortunately, there have been a couple of cases of mismanagement or fraud within states’ 529 programs. And, as with any other investment, returns will be subject to market fluctuations. You’re not guaranteed a specific amount of growth.
Why Bother with a 529?
“But I already have a savings account, and I can use it for whatever I want. Why bother with a 529?”
Why yes, dear reader, I can read your mind. Or rather, I can imagine you have the same questions I did. (Same thing, right?) More to the point, though, 529’s do have a few advantages over a regular savings account or mutual fund, even though they tend to have similar rates of return on investment.
The Tax Advantage
The biggest advantage of a 529 over more traditional investments is that 529s are tax-free. With an ordinary investment account, you’re taxed both on the money you put in (as part of your regular income taxes) and any returns you make on the investment. With a 529, while the money you put in is not tax-deductible (as it might be if you donated to a charity), the return on investment is. So as long as the funds are used for qualified school-related expenses, it won’t count toward your own taxable income. Additionally, many states offer their own tax breaks to incentivize the use of a 529 and encourage saving for college.
Competitive Market
Although there may be some tax advantages to enrolling in a plan with your own state, you don’t have to. Most 529 savings plans are open to residents of any state. And here’s the kicker: you can have plans in up to 44 different states at the same time! Now, most folks won’t need nearly that many, but if you had the means to invest in that many, you totally could if you wanted to.
This means that state plans have to compete for your business, which is good news for you. It incentivizes states to offer a variety of plans that will work in your best interests. If you (or your parents) have a financial advisor, they should be able to help you sort through the different plans available to you. For the rest of us, there are a couple of websites like this one where you can compare different plans against each other to find the one that best fits your means and needs.
What If You Don’t Use the Money?
One of the common concerns about 529s is what happens if the original beneficiary of a plan doesn’t end up needing all (or possibly any) of the money saved when they get to college, or if they decide not to go to college at all. What if you start a savings plan, but then you earn a full-ride scholarship to your dream school? In either case, the 529 comes with a couple of options to deal with this.
The first is to simply name a different beneficiary (or merge accounts, if they already have a savings plan in the same state). This can be done without fees or penalty charges. Alternatively, you could simply withdraw the money. If you are withdrawing because you got that full-ride to Yale (go you!), then you will only owe back-taxes on the returns from the account. If you have simply decided that college isn’t for you, you can still withdraw the money, but a 10% fee will be deducted from the amount withdrawn on top of those back-taxes.
“Qualified Expenses”
Okay, so by now I’ve referred to this idea a couple of times: a 529 savings plan works on any “qualified school expense.” But what does that even mean?
Unfortunately, not everything you technically need for school counts as a qualified expense. If I could buy a car using my financial aid, you could bet your overpriced college textbooks I wouldn’t be spending my time on the convoluted city bus routes between my home and campus. But alas, the U.S. Department of Education says Pell doesn’t work like that, even if you go to a commuter school. (Sigh.) So what does count, then?
What Counts?
Actually, the Pell is a decent place to start. If you’re familiar with what you can do with a Pell Grant, you’ve got a good idea of what can be bought with a 529, too. Well, the savings plan, anyway. As mentioned previously, a prepaid plan only applies to tuition and school fees. With a savings plan, though, tuition and college fees will be covered, as well as books and supplies needed for the class (yes, even your rainbow gel pens and pony-licious backpack). If your class requires a computer and internet access, that can be covered as well, so long as it is primarily for school. If you’re enrolled at least half-time (as determined by the school in question), a 529 savings plan can also pay for room and board up to the amount accounted for in the college’s “cost of attendance” estimate. If you are a student with special needs, such as a wheelchair, special desk, or if your condition requires special transportation considerations, those are covered as well. Just be sure to keep your receipts. If you’re audited, you’ll need to be able to prove that the money was used on school expenses.
What Doesn’t Count?
Unless you have a special need, as stated above, transportation costs don’t count. So no, I wouldn’t be able to get my car with a 529, nor could I pay for gas with it. Health insurance also won’t count, even if the policy is offered by your college. Application and testing fees, as well as expenses for extracurricular activities, won’t fly either. And you can’t use a 529 to pay off existing student loans.
Now, technically, this isn’t to say you can’t withdraw your money and then use it for these things. But remember that any withdrawal that can’t be counted as a qualified educational expense comes with a 10% fee, and you will also owe back-taxes on the amount withdrawn. So I wouldn’t recommend it.
What's the Catch?
I realize this is quite the rosy picture I’ve painted for you, and you’re right to ask questions. As with any major financial decision, there are always reasons people will tell you not to get a 529 plan.
Reducing Financial Aid Options
“The government will give you less money. ” This seems to be the most common cautionary statement I’ve seen regarding 529s. (If you don’t believe me, open up a tab real quick and google “529 financial aid.” I’ll be here when you get back.)
This statement tends to be overblown, though. The average reduction in financial aid is only around 6%. For reference, if a full-time student who was completely dependent on financial aid had that much deducted from their Pell Grant last semester, they only would have lost about $160. That’s less than the price of many college textbooks. They would have lost a slight bit more from any Stafford Loans they had, but those have to be paid back with interest anyway. Even so, it is important to keep in mind that financial aid is distributed based on perceived need. So if you have assets to use, the government would rather give their money to someone who doesn’t.
Other Considerations
Other factors to consider when deciding if a 529 is for you are much the same as with any other savings or investment. Growth is based on interest rates and investment income, so it needs time to accrue. It isn’t a magical money machine; you need to have money to put into it. And, much like with any savings fund, there’s a risk that in times of financial crisis, the state may not have the funds it owes you when you need them.
How Can I Get Started?
If you’re interested in getting started with a 529 plan, consider talking with a financial advisor. They will be your best bet. A financial advisor will be able to help you work out if a 529 plan is right for you and, if so, which ones work best for your particular situation.
Unfortunately, most people don’t have a dedicated financial advisor. Fortunately, there’s still help for us.
SavingforCollege.com has a great resource page for comparison-shopping for your 529. The page also has additional information about the plans and can help you find a professional to advise you if you need it.
As for when to start, generally the sooner you open a 529, the better it works. This is especially true in the case of the prepaid plans, which are designed around locking in a price against future inflation.
Like any investment or savings account, a 529 plan benefits from time. The longer you have it and the more money you can contribute over that period, the more you will have available by the time you use it. However, even if you’re already in high school (or in college like me), you may still benefit from the tax advantages of putting the rest of your college savings into a 529. After researching for this article, I’m seriously considering getting one for myself, as I plan to go back for a higher degree later on down the road.
Already have a 529 savings plan, and just looking for ways to make the most of it? Accelerated Pathways can help. Our academic advisors are dedicated to helping you graduate college 100% debt free. That means they’ll work with you to find the most affordable and effective path toward your bachelor’s degree. Make your 529 savings plan go further with Accelerated Pathways advising and our incredibly affordable online courses. Check it out now!