As many of the Gen Y or Millennial generation are getting in their mid-30s, one of the things in your mind is probably getting married or having a baby soon. As you push through the financial jargon, like 401K, IRA, life insurance, beneficiaries, and more there’s another number that may crave your attention. It’s known as a 529 Plan and is designed with your future children in mind. But what is it and why should you care?
What’s a 529 Plan?
A 529 plan is an investment account that is designed for education and when used for such it gets special tax benefits. Many US States sponsor a 529 Plan for their residents promoting features such as tax deductibility and tax-free use of the money for educational expenses, such as tuition, room & board, books, computers etc.
Why should you have one?
With college tuition getting more and more expensive, many parents would like to help their kids to reduce the amount of debt they’ll need to take. In the last couple of years, an in-state public tuition for four years (not including room & board) has been close to $40,000 (according to College Board). With an annual inflation in costs of about 5% each year (that’s been the case in the last 10 years) that is projected to be close to $100,000 in 18 years when your unborn is ready to go to college. There are technically just 3 choices:
Let the kid figure it out and get tons of loans
Find an alternative way besides college or ‘online something’ that has value or
Plan for this major expense and start saving something now & early. The below will evaluate the options you have if you decide to go with #3.
Source: SavingforCollege.com – Based on average tuition and fees for 2014-2015 as reported by The College Board® and assumed to increase 5% annually. The figures above do not include other costs your child will incur as a college student, such as room and board, books, supplies, equipment, and transportation. These additional expenses can increase your child’s cost of attending college by a substantial amount.
Which plan to get?
This is where it gets complex. Most states sponsor a plan or few for that matter. Most of them have a ‘prepaid option’ for in-state tuition at a state college, where you pay a fixed amount now for college in the future. You can also make payments on it if cannot afford just a lump-sum, which many of us cannot. This plan assures that no matter what happens to the tuition at the time of need you will have already prepaid it and the state owes you semesters of education, no matter what the price is. While typically these ‘prepaid plans’ remove the hassle of investing and not knowing what will happen, they also restrict you to in-state colleges. But maybe your kid would like to attend that very prestigious Ivy League out-of-state college.
I’ll focus on the investment plans, which are known as 529 Plans. These plans are just investment vehicles where you can purchase different investments based on the sponsor and the state.
Taxes
A 529 Plan doesn’t pay any taxes on any gains as it’s growing over time, and withdrawals for education expenses are federally and state tax-free. In a sense, it works just as a ROTH IRA where you put money and withdraw all of it (including earnings) without paying any tax. Some states sweeten the deal even more by offering tax deductibility for the contributions (money you put in year after year). Each state has its own laws, but on average they allow up to $5000 tax deduction on the state taxes only, but no federal tax deductibility applies.
Investment Options
Most 529 plans have similar investment options. They typically offer an ‘age-based track’ where you pick a fund based on the age of the child (beneficiary of these funds) and then the fund does its own thing and gets more conservative as the time to college nears. They also have ala-carte funds you can pick. As with most investments, the idea is to diversify and keep costs as low as possible, so while they have similar investment options fees vary from one plan to another.
Fees
Fees vary and they typically come in two forms, administrative fees (for operating the 529 program) and investment fees of the underlying investments. Many states don’t have administrative fees, while some have it in dollar amounts (like $25/year) or in percent of assets (like 0.25%/year). Most investment fees vary from the very low of 0.1% up to over 1%/year in some cases. Fees matter a lot, as being one of the most critical factors for performance, the lower the better.
Which one to choose
First, you need to start by looking if your state gives a tax break for investing in the state-sponsored 529 plan. Many states don’t offer a break, including all the states that don’t have an income tax (Florida, Washington, Wyoming, South Dakota, Nevada, Alaska, Texas, New Hampshire & Tennessee) but many other states justdon’t care to offer a tax break while having an income tax, like California, Delaware, Hawaii, Maine, New Jersey & North Carolina.
So for these 15 states, the state tax deductibility is not on the table, making you as a resident of these states more prone to evaluate other options, outside your state. For the ones that get a tax deduction on their state income taxes, from my research it varies but based on a $5,000 annual contribution you could save on average about $200/year in state taxes. This is a strong reason to join your own state-sponsored 529 plan, but only if the investment costs are still reasonable and if you reinvest those tax benefits into next year’s contributions.
If you’d like to help your kid(s) towards their education, funding a 529 plan is a good way, and many states give a tax benefit for participating. Invest what you really can, but without jeopardizing your own retirement. At the end they can get some loans, your retirement doesn’t have more time after being short. For the states that don’t have a state income tax or don’t offer a tax deduction for the contribution, it’s good to look at other states’ 529 plans that allow non-resident participation and many do so. Look for wide diversification, age-based options and low, all-in costs at or below 0.5%/year. The key is to start as early as possible. And by the way, did you know that you could have a 529 plan even before having any kids, giving you even more time to save? It may be worth to take a look at.
Let us know if we can help with your next 529 plan research or any questions you have about this plan.
