Saving for a child before you even have one might seem like an impossibility, but it’s actually not. Thanks to a savings plan called a 529, you can start saving for your future child’s education costs well in advance of actually having any rugrats of your own. And these plans can even help you save on your tax bill.
Since college is one of the most expensive purchases most people make, the earlier you can start saving, the better off you’ll be. Starting early means time is on your side; if you start saving for a child’s college expenses 25 years before they start school you’ll have a quarter of a century worth of interest built up.
Best of all though, you don't have to use the money in a 529 just for college. You can opt to use the funds for vocational and trade school, or use $10,000 per student to cover tuition at a public or private K-12 school.
What Is a 529 Plan?
A section 529 plan is a higher education savings plan organized and operated by each of the 50 states (as well as the District of Columbia). You can open one at any time, including before whoever may use it is even born.
Nor are you limited to opening a 529 in the state you live in; you can open one almost any state you want. For example, if your home state has fees but a neighboring one doesn’t, you can open your 529 in the fee-free state. You’ll skip the fees, earn the interest, and make yourself even more money.
529 earnings are not subject to federal tax, and you won’t owe Uncle Sam when you take money out of the account. Though plans vary from state to state, earnings are also generally not subject to state tax when used for qualifying education expenses like tuition, books or room and board. Two-thirds of U.S. states also offer a deduction or credit against their own income tax for contributions to the home-state plan. (There’s no federal income tax deduction for these plans.) There’s also no limit on how many plans you can open, so you can start one for each child you have (or plan on having).
What’s more, you can open a plan in your name today and change it when your child needs access to the funds. So you don’t have to open the account in your unborn child’s name for them to use the money someday. All you’ll need to do is change the beneficiary on the account.
How Do I Open up a 529?
To open up a 529, you’ll need to go through either your state’s sponsored administrator or a private advisor.
Each state selects a brokerage administrator to be in charge of its 529 plans and work with investors. You deal with the administrator, not the state directly.
Or you can open a plan with a private advisor like Wealthfront. Often, these plans will be cheaper, but they may offer less guidance than the state-selected plans. You’ll need to form an account with a private advisor, but you can do so from the comfort of your own couch. Nothing wrong with that! (In fact, here at Investor Junkie we like Wealthfront so much we’ve named it the top robo advisor.)
What to Look for in a 529 Plan
It's important to be picky when you are looking for a 529 plan. You want to make sure that you are getting the best for the child in your life, and it's nice to know that your money is being put to good use.
- When considering a 529 plan, you want to first make sure that your child will be able to go to any school he or she wants to attend. Most state plans are good at schools in other states, but there are some plans out there that restrict your choices. First of all, make sure that there are more options for the child's schooling.
- Next, look at investment options and fees. Some states sell plans directly, which means that there are lower fees involved. A state that has a plan that is broker run can cost a little more, coming with higher fees. Another consideration is what types of investment options you have with the state plan. Many states allow you to add funds to your 529. Find out whether the funds come with high fees. A range of low-fee fund options can be a great choice.
- Finally, consider state tax deductions. Some states, like Texas, Nevada, Florida, and others offer no tax benefit for plans at all. Most states, though, at least offer a tax break for in-state residents who invest in the state's plan. A few states, like Maine, Pennsylvania, Missouri, Kansas, and Arizona will give you a state tax deduction for investing in any 529 plan — even if it isn't your resident state's plan. Many platforms offer to manage your 529 plan using their services, such as Betterment and Wealthfront. We strongly recommend considering these services.
- Don't forget that you can use a 529 for up to $10,000 per student for public or private elementary and secondary school. You can also use the funds for other expenses besides college tuition, like room and board, meal plans, and books.
The Two Types of 529 Plans
There are two types of 529 plans: prepaid plans and investment plans:
- Prepaid Plans: With prepaid plans, you can pay for a stretch of tuition ahead of time. It’s usually a year, but plans can work with you on how long you want to pay for. By prepaying, you effectively lock in a tuition rate for your child’s future education. Tuition price changes won’t affect you. Unfortunately, not all states offer prepaid plans, and you can use the money only for tuition (not room and board, books, etc.).
- Investment Plans: With investment plans, you decide how you want to invest your money and have the discretion to spend the total amount (earnings and principal) however you want. You can use it for books, tuition, room, and board — whatever-related costs you need it for.
(Note: It is possible to use 529 funds for non-educational needs if absolutely necessary. If you need the money for something like medical bills, you’ll pay income tax rates on the gains, plus a 10% penalty to the government. If something else happens, like your child wins a scholarship, becomes disabled, or passes away, you can withdraw money out without paying any penalties.)
Some employers offer 529 plans as part of their benefits package. Check with your employer to see if that’s the case for you.
However, no matter what type of plan you choose or how you get it, keep an eye on fees; annual and investment fees can be big money drains.
Tips for Getting the Most Out of Your 529 plan
- Start as early as possible. The best advice for retirement savings is also the most important when college costs are concerned: start early. Even if you don’t plan on paying for most of your child’s college education, opening a plan when they are young (or, even better, when they are born) provides the maximum opportunity for the plan to grow over time.
- Get a 529 savings plan. There are two types of 529 plans: savings plans and prepaid versions. While both confer advantages upon the student and the student’s family, the savings plan is usually preferable as it allows for maximum returns. This is because prepaid plans simply hedge against inflation while savings plans allow for full investment in the market.
- Know which funds are being invested in. While it is best to keep a hands-off approach with your 529 plan from a spending perspective, this does not mean you should ignore where your money is being invested. On this note, make sure that you know what underlying investments (likely mutual funds) constitute the bulk of your fund.
- Lower your risk as payment approaches. Some people are too conservative in their 529 investments and others tend to take too many risks. Perhaps the best way to forge an appropriate balance (a balance that ensures maximum returns without putting savings in jeopardy) is by balancing the fund to make investments less risky as college payment approaches.
- Spend all plan money on tuition, books, and related college costs. This may go without saying, but one of the major disadvantages of the 529 plan is that it incurs a heavy tax penalty if any funds are spent on non-college costs. This issue can be avoided by simply being responsible with the way you draw cash from the account. The exception is to use up to $10,000 per child for private and public K-12 school or vocational or trade school tuition.
These are some of the main tips to keep in mind when using a 529 plan. Although the plan somewhat limits a person’s investment options and can lead to significant penalties if incorrectly used, there are few better options when college savings are concerned.
Five Best 529 Plans for Good Value
If you are looking for a 529 plan, you might try one of the following 5 plans that offer solid value:
- Ohio: This is the plan that I invest in for my son. Ohio offers a wide range of low-cost investment options. Plus, it's sold through the state so the fees are a little lower. I don't get a tax deduction for my contributions, but Ohio residents can get a deduction for up to $4,000.
- Virginia: Once again, this plan is administered through the state. What's awesome about Virginia's plan is that, while residents can only deduct $4,000 a year, you can carry the excess forward to other years. Plus, if you are more than 70 (making contributions for the grandkids) you can deduct the full amount of your contribution.
- Iowa: The plan sold by Iowa is direct, so you have the lower fees. Iowa's inflation-adjusted contribution is currently $3,439 per beneficiary. There are some solid investment choices, including low-cost funds from Vanguard.
- Nebraska: There is a reasonably generous $5,000 tax deduction for residents ($10,000 if you're married, filing jointly). You do need to be careful, though, since Nebraska has a direct version and a broker version. If you want to save on fees, the direct version is likely a better choice.
- Illinois: The biggest advantage to the direct-sold Illinois plan is the $10,000 deduction ($20,000 for joint filers) for resident contributions to the 529 plan.
With this in mind, then, it is important that every student and family understands the 529 and knows how to maximize the benefits.
Starting a 529 plan for children you don’t even have yet is a great way to give your future kids a huge leg up on paying for college. And starting early means you can put away money in smaller chunks over time. Start by seeing what the terms of your state-sponsored plan are, and then compare them to private advisors.
If you decide to open up a 529, the money will be there for your child when they need it. Plus, you’ll have peace of mind knowing you can pay for whatever degree they want to get.
InvestorJunkie receives cash compensation from Wealthfront Advisers LLC (“Wealthfront Advisers”) for each new client that applies for a Wealthfront Automated Investing Account through our links. This creates an incentive that results in a material conflict of interest. InvestorJunkie is not a Wealthfront Advisers client, and this is a paid endorsement. More information is available via our links to Wealthfront Advisers.