Learn exactly what a 529 College Savings Plan is and learn the different key factors you should be looking for when you’re opening one up.
(Watch the video version of this article here: YouTube Link)
This is my daughter. She’s only 2 years old and all she cares about is running around the beach and riding her scooter in our neighborhood. But one day that’ll change, she grow up and want to be a doctor or engineer or maybe even a pro golfer!
Whatever her aspirations are, I know there’s a good chance that she’ll want to go to a specific college, in order to accomplish her goals. And as a parent, I wanna make sure she gets there.
And one of the best things that I can think of to help her get the education she needs — is to invest in a 529 education fund.
So in this article, I’m going to go over exactly what a 529 is, and walk through the different key factors you should be looking for when you’re considering opening one up.
Welcome to Daniel’s Brew — where I cover personal finance, investing, and career development topics.
What is a 529 College Savings Plan?
Simply defined, a 529 is a state sponsored tax advantaged education savings plan designed to be used for qualifying educational expenses, including school tuition, room & board fees, books & supplies and even college meal plans.
The first 529 plan was founded at the Michigan Education trust in 1986 as a College tuition savings plan, but over the years as more and more 529s began to emerge, the definition has grown to cover more types of educational expenses .
And most recently in 2019, this investment vehicle’s scope expanded to include K-12 private school tuition, as well as registered vocational/trade school tuition — like culinary institutes, cosmetology academies and film schools.
By the way, in case you’re curious, it’s called a 529 plan, because the section of the Internal Revenue Code that authorizes this type of savings plan, is section 529.
What expenses qualify under 529?
Next let’s take a deeper look at which expenses qualify under this program.
As we discussed, you can now use your 529 to pay for a wide range of educational institutions, from k-12 private schools, to colleges and even vocational & trade schools.
If you go to this Federal School look up tool on savingsforcollege.com, you can actually look up just about every single school and institution that qualifies under the 529. Simply fill out the details on the form and you’ll get a comprehensive list of schools to review.
In terms of what types of expenses qualify under a 529, here is a list of things that are included:
1) School tuition, fees and student loans payments — that’s right, you can even pay off student loans with a 529.
2) Room & board, which includes both on-campus & off-campus housing options.
3) Food and meal plans, which include on and off campus options.
4) Books and educational supplies — like notebooks, pens, calculators, etc.
5) Computers, software and certain education related tech products — although for this one, you have to have some documentation saying this is a necessary educational need for your institution.
For example, the Design Media Arts school at UCLA has a laptop requirements document that outlines what type of laptops students will need to be successful in their course work. If you have something like this — then these purchases would count under a 529 plan.
6) Internet service — a lot of people are unaware that internet service is actually seen as a necessary tool for education and thus, qualifies under 529 usage.
7) Any special needs equipment or accommodations that a student might need, in order to effectively engage in with their course work. This includes wheelchairs, certain types of transportation costs, etc.
And here are a few things that you would think should qualify under a 529 expense but actually don’t.
a) Transportation and Travel — so for example, buying a plane ticket to fly from school to home and vice versa wouldn’t be covered as a qualifying 529 expense
b) Smartphones, iPods, cameras, any other general everyday use electronics would typically not be covered under a 529 unless your studies specifically documented the need for such devices.
c) Gyms and sports club memberships are excluded here as well — but in most large universities, an on campus gym membership is usually included in your tuition, so this may not be as big of a deal.
d) and lastly any health insurance for a student is generally not covered here either, under the plan.
Features of a 529 College Savings Plan
Now that you know what a 529 is and what it’s purpose is, let’s talk about some of the unique features of this investment vehicle.
(1) First, there are no yearly contribution limits to a 529, unlike an IRA or HSA — that has specific yearly contribution amounts that you can’t exceed. But 529s usually have a total value cap for the account. So for a 529, you can contribute as much or as little as you want each year — but only up to the total account value limit, which is usually in the area of around $500k.
(2) Next, these plans, generally come in two different flavors — a pre-paid tuition plan, and an education savings plan.
A prepaid tuition plan works exactly like it sounds, it allows the account holder to purchase credits at participating schools, usually public colleges that are in-state, for future tuition and other fees involved with enrollment. The benefit of the pre-paid plan is that it allows you to purchase these credits at current prices — so that if the price of tuition rises later on, you would have paid a much cheaper amount for that same credit.
The only downsides to this approach is that you can’t invest your money because it’s not put into an investment account, rather they are stored as purchased tuition credits, at a particular university and for this method you have to select and be locked into the school you chose from the beginning — as these credits are generally not transferable to any other school.
But if you look back at history, the prices of tuition nationally have gone up over 25% in the last 10 years. So if you’re certain about what school your beneficiary wants to go to in the future, pre-paying for tuition credits can be a pretty smart move.
The 2nd 529 flavor is the Education Savings route and in this method, the account holder opens an investment account and saves for the beneficiary’s qualified education expenses in the future — much like an IRA or HSA.
And from a tax viewpoint, the 529 is a double tax advantaged account — where you contribute after-tax dollars, and it grows within the account tax free and withdrawals from the account are also tax free, as long as it’s for qualified educational expenses.
(3) The third thing to note about this program, is that there is no one national plan because 529s are all state sponsored, meaning each state has and runs their own program.
Now, this is really important to understand — because for a prepaid tuition program, while you can choose ANY state’s plan, this means that you have to pick a specific school to contribute to and when you are ready to reap the benefits of your contributions, I.E. use the tuition credits — you can only use it for that particular school.
And in the pre-paid tuition route, when it comes time for you to use the funds, some programs actually require you to be a resident of that state — which means you would likely have to move there if you opened up a pre-paid 529 plan in any other state besides the one you are currently residing in.
Far more flexible, is the education savings plan.
In this one, you can contribute to any state program and withdrawal to use the funds for any other state educational expense, regardless of where you live. So as an example, you could be a resident of say, Texas, and set up a 529 in California, or be a resident of Michigan and open an account in Alabama and in either of those cases, make a withdrawal and pay for tuition in New York, if that’s where your beneficiary decided to go.
So then, an obvious question you’ll want to ask is, “If in the education savings plan, I can use the funds for any state school my beneficiary wants, does it matter at all, which state program I initially sign up for and participate in?”
Well, the answer is Yes — and here’s why.
How to Choose a 529 Savings Plan
There are 2 main considerations to make when choosing the right state sponsored education savings plan.
1) The first is — Local Tax Consideration. You see, if you live in a state that has state income tax, most of those states offer some type of local state tax deductions for contributing to a 529 program. In this case, your contributions would be partially tax free because of this deduction benefit. But one thing you have to watch out for, is that certain states may require you to then use the funds within their state, or pay back some of the tax deduction amount later in distribution. So you’ll want to make sure you check with the fine print before going with your state’s 529 plan, if you’re in it for the upfront tax savings.
2) The second consideration is Investment Choice and Account Performance. Each state’s 529 is powered on the backend, by a certain brokerage or financial planning firm that the program has a partnership with. And through that partnership, there are usually a specific set of investment options that are uniquely provided for that program. And these choices are typically objective or risk based portfolios that they create and manage on your behalf. These portfolios usually have a collection of underlying mutual funds or bond funds and their mix is determined by the portfolio strategy.
Here is an example of some investment choices with New York’s 529 program.
As you can see, it looks like this program partnered with Vanguard for their investment vehicles and they seem to offer a good mix of growth and balanced investment strategies in their offerings.
One thing to remember, is that because you don’t have much say in what the underlying funds are within your portfolio (since it’s managed by the program itself), it’s important to make sure you look at the performance of these funds over time, before you commit to a particular state’s program. There is usually a historical performance section in most 529 websites where you can compare how each portfolio does against their underlying benchmark. And if you do some research, you’d be surprised at how much of a difference the portfolio’s performance can be across different state programs.
So make sure you invest a little time to do some comparisons between state 529s — before you commit to one.
And lastly, let’s briefly cover the logistics of setting one up a 529 account.
First, before you decide to sign up, let’s talk a bit about who can be a beneficiary for this account. Most people think 529s are only for parents — who are planning out long term education goals for their young children. But the truth is, the IRS’s definition of a beneficiary for this plan is pretty broad and includes:
- Spouses
- Sons, daughters, stepchildren, foster kids, adopted children
- Sons-in-law, daughters-in-law
- Siblings or step-siblings
- Brothers-in-law, sisters-in-law
- Fathers or mothers
- Fathers-in-law, mothers-in-law
- Aunts, uncles
- Nieces, nephews
- Or any first cousins.
And while a 529 plan can only have one beneficiary at a time, switching beneficiaries can be done at any time you want, without any tax implications — as long as you continue to use the funds only for qualified expenses.
So once you know who your beneficiary is going to be, it in terms of actually signing up for the account, the easiest way I’ve found to do this is to go directly to each state’s 529 website and register directly.
This is the best way because it’ll provide you the most comprehensive detail on that particular state’s program itself, not just on the investment piece and are usually the most informative when it comes to details and insights on how you can make your dollars go further within that specific state 529 plan.
All you have to do is simply fill out the registration form and agree to open up an account with their partnering brokerage firm to hold your investments in (which happens automatically by the way, as part of this registration process) and just chose which investment strategy you want your contributions to follow. And that’s it — it’s no different than signing up for a brokerage account or individual retirement plan at a financial planning firm.
In closing, the cost of education continues to rise in this country, so saving NOW for your child or beneficiary may end up being one of the most prudent things you can do your them. It’ll take a little bit of careful thought and some research on your end but at the end of the day, it’ll be time and effort well spent.
Related articles:
Follow Daniel’s Brew: YouTube | Twitter | Instagram | Medium
**** Disclaimer *****
The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial, investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.
