Written By Travis Hornsby, CFA®, CFP®
Paying for a college education through personal savings and investments is simply impossible for most students. Unless you are among the privileged few whose parents had the resources to save for your college education, you’ve probably struggled with student loan debt.
And you’re not alone. More than half of college attendees in America take student loans to pay for their education.
According to the Federal Reserve Bank, the average student loan debt is $37,500 as of December 2020. And this keeps growing due to the soaring college costs.
If you already have student loan debt, you have many options to optimize the situation and still live a comfortable life while saving up for your retirement. At Student Loan Planner®, we help you figure that out when you book a consult.
But what if you could plan ahead and take advantage of the system and programs to make the situation much better for your kids?
You can, with a 529 plan. Here’s what you need to know.
Two types of 529 College Savings Plans
Unless you’re super-rich and can afford to pay for your kids’ college education directly from your income, you’ll most likely need to build up an education fund over a long time. And that’s where the 529 College Savings Plans come in.
529 College Savings Plans are state-run savings plans designed to help parents or guardians pay for kids’ education.
There are two types of 529 college savings plans. One is the ordinary 529 plan, and the other one is the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) 529 plan.
The Difference Between a 529 Savings plan and UTMA/UGMA
A 529 plan is a tax-deferred savings plan designed to save for education specifically. Initially, it was limited only to college education costs, but it was later expanded to cover educational expenses from kindergarten to graduate school.
Parents or guardians mainly set it up on behalf of their child, who is the beneficiary of the account, to reduce or eliminate the student loans they need for college.
A UTMA/UGMA 529 plan can be used for any purpose. This is basically money that you stash away for a minor where the money transitions to the child when they reach the age of majority.
For a UTMA/UGMA 529 plan, you contribute after-tax dollars, so there are no tax benefits. You pay regular capital gains taxes when you pull money out of a UTMA/UGMA account.
Pros of a 529 Plan
Apart from helping your kids avoid taking massive student loan debt to take them through college, there’s a lot you stand to gain from setting up a 529 savings plan:
You get tax benefits
A 529 plan gives you a state tax deduction for income taxes on the money you put into the account, up to a state-specified limit.
The fund grows tax-free. If you withdraw the funds to use for qualified education expenses, then you can do so tax-free.
However, if you take money from it for any other reason, you’ll pay ordinary income tax plus a 10% penalty tax on the earnings.
You can change beneficiaries any time
A 529 plan is restricted in terms of how you can use the money, but it’s flexible on the part of beneficiaries.
For instance, let’s say you have two kids, and the one you had indicated as the beneficiary gets a full scholarship, and the other one does not. You can easily change the beneficiary of the 529 account to the other sibling.
Worst-case scenario, if your kids don’t go to college or don’t have to pay for college expenses, then you can change the beneficiary to your grandkids or to cousins, nephews or nieces.
It’s an opportunity to double your savings
There's a rule called the Rule of 72 that tells you about how long it will take for your money to double. So, take 72 divided by the percentage investment return, and that’s the number of years it will take for your investment to double.
For example, if you contribute $10,000 to your kid’s 529 accounts and you have a 7% return on investment, that means your money will double about every ten years.
There's a good chance that you could have four times as much money by the time your kid is going to college if you put $10,000 in the account when they’re born.
Cons of a 529 Plan
As with most things in life, a 529 savings plan has its downsides. Here’s what to watch out for:
You must use funds for education purposes
You could face tax penalties if your kid doesn't end up going to college. To use the money you saved in a 529 plan for something other than education, you will have to pay income tax and a 10% penalty to withdraw the money and use it for other purposes.
That's one reason why you don’t want to overfund a 529 account. It is better to have a modest sum of money saved in that account and invest elsewhere if you have a surplus.
Some have high fees
A 529 plan comes with fees. The more you pay in fees, the less money that goes toward college savings. Direct-sold 529 plans generally have cheaper fees than ones you can get from an advisor. But expenses can vary, so it’s important to research your options.
You can find a low-cost option that meets your needs for saving for your child’s education.
How to open a 529 account
Opening a 529 account is pretty simple. First, figure out if you need to open the 529 account through your own state's plan to get an income tax deduction or if your state allows you to open it in another state.
Some states allow you to open a 529 account anywhere and still receive an income tax deduction. Some of these are Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana and Pennsylvania. Be sure to check with your state because some don't give any tax deduction for having made 529 plan contributions.
Next, you need to select a suitable college savings plan. One company that I highly
recommend is Vanguard. Vanguard also has a tax calculator that you can use to calculate how much tax benefit you could get.
Finally, go through the process to open the account, complete the documentation and fund your account.
How much should you save in a 529 Account?
The amount of money you put in your 529 account depends on how old your kid is and where you want them to go to college. If you have an early start, you can contribute the minimum amount to get it started.
Over time, you can calculate how much you’ll need to save to fully cover your kid’s education and upgrade your contribution.
Here’s a rough idea when deciding how much to send to a 529 account:
If your goal is to have your kid go to a public institution, then $250 per month is a good amount to contribute. You might save $500 per month if you want to send your kid to a private institution or $1,000 per month to save enough for an Ivy League college.
Remember to prioritize yourself first
Saving for college for your kids and grandkids, while noble and admirable, should never take precedence over your own financial needs. You have to “put your oxygen mask on first” before helping others.
If you do a great job of saving for your kids’ college but neglect to save up for your retirement, you may become a financial burden, and your kids could be forced to support you.
Prioritize putting money into your retirement accounts and into a brokerage account to secure your retirement before everything else.
If you’re anxious to get started but don’t have a lot of money, consider opening a 529 account and making the minimum contributions until your finances get more stable.
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