The younger physicians I help with their financial planning often have questions regarding saving for college for their children. So, I thought it would be helpful to write a post to explain what a 529 college savings plan is and if it’s even worth opening.
Like everything else in financial planning, the answer to this question will really depend on your current financial situation and the goals and objectives that you want to achieve.
What is a 529?
A 529 is a savings account designed for higher education (college).
Yup, that’s it.
You put money in, watch it grow over the next 18 or so years, withdraw from the account during the time your child is in college. Genius, right?
I could give you more details with fancy words, of course, but that is the most simplistic definiton. It really is just that easy.
When Does a 529 Make Sense?
Investing in a 529 makes the most sense when you have all of your other priorities on track. You can find out if you’re on track by asking yourself a few questions.
- Do you know how much money comes in (earned income) and how much money goes out (your spending) every month?
- Are you fully saving for your retirement in your 403b/401k and maxing out your IRA’s?
- Do you have an adequate emergency fund set up and fully funded?
Saving towards a 529 plan also makes sense when you have a reliable and significant amount of money to contribute and you can contribute the money early in your child’s life.
It really doesn’t make sense to set up a 529 plan for your freshman in high school. The earnings growth potential is quite limited with such a short investment time horizon. Plus, the tax benefits will more than likely not outweigh locking your funds into a 529 account. The longer the length time between now and when your child will need the funds for college, the more it makes sense to invest in a 529.
What are the Benefits of a 529?
A 529 will not lower your taxes by contributing exactly it like your 401k does. There are, however, 30 or so states that give a tax deduction if you live in that state and contribute to a plan in that state, but that isn’t always the best option.
While I’m not going to list each state and its benefits, a quick google search can help you find out if your state offers a deduction if you open a 529 with them.
It’s important to note that you don’t need to open a plan in the state in which you reside, and the state that holds the 529 does NOT mean you child has to go to college in that state. To put it another way, you can open a 529 account in any state, and your child can go to a college in any state. In fact, if the child you are saving for decides that they don’t want to go to college, you can change the beneficiary to other one of your children, a relative, or even yourself to use the funds for higher education expenses.
If there is no one to transfer to, you don’t lose it. You would be allowed to withdraw the money, but you will have to pay the tax on the capital gains as well as a 10% penalty to the IRS. If you end up not using all of the money in the 529 due to your child receiving a scholarship, the IRS has some exceptions in place.
Here are some other benefits of a 529 plan:
- Federal Tax Breaks – Your money grows tax free and you are not taxed when its taken out if used for college
- State Tax Benefits – Over 30 states offer residents a tax deduction for contributing
- You Have Control – The fund are yours for the entire life of the account. (The beneficiary has no legal right to the money in the 529 account.)
- Low Maintenance & Quick and Easy to Set Up
- High Contribution Limits – Assuming you’re married, your family can contribute up to $28,000/yr per child without any tax consequence.
- Automatic Investment Options – (See the recommendations below for an example.)
- Professional Money Management – This is if you have a financial advisor.
- Simple Tax Reporting – There is nothing to report on your taxes until you take a withdrawal.
- You Can Change Your Investment Options Twice a Year
- Everyone is Eligible – There are no restrictions with regard to income, employment, or age.
When is a 529 Might Be a Bad Idea
As mentioned, as your child gets closer to the age of using the funds to pay for higher education, the benefit of a 529 plan starts to diminish rapidly.
It would also be bad if you were to contribute very infrequently or with a minimum amount (say $50/mo) with no expectation to increase the amount. The tax benefit wouldn’t outweigh the fact that this money is tied up in a 529 that really wont pay for much education and potentially could have been used to invest in something else that would have provided additional benefit.
If you haven’t taken care of your own financial health and retirement, it would be a bad idea to really contribute in any high dollar amount to a 529 plan.
Maximize your financial future, then worry about your children.
The 529 Plans I Recommend
Nearly every state has their own plan and some states offer multiple plans. Each plan has its own investment options, fees, rules etc, and it can get quite confusing quickly.
So, I’ll help you out and do some of the heavy lifting for you. Here are my top two choices for your 529 plan assuming that you do not qualify for a state deduction or do the calculation and find out that the deduction doesn’t provide enough of a benefit due to high costs of the plan (likely).
I like this plan, called the UNIQUE college investing plan (offered through Fidelity), because you are able to purchase total market domestic and international index funds at an extremely low cost compared to every other 529 out there. The total market fund has an expense ratio of just 0.11%! The rest of the options are pretty awful investments, but you’re not in it for those investments anyways. Fidelity has an extremely easy interface to navigate and the online application and setup might be the easiest in the industry.
Utah 529 plan
This is a great plan that has some high quality investment choices. They have Vanguard index funds as well as DFA mutual funds (typically only available through an advisor). If you are working with an advisor, the Utah plan allows your advisor trade only access to your account so they can manage the investments for you. It allows for highly customizable features that allow you to set specific investment selections for each age of your child. So if you wanted to have less stock vs bonds as they get older, you can automate the change from aggressive to more conservative. I don’t believe that any other plan allows for this type of investing. With that said, the Utah plan is slightly more expensive than the New Hampshire plan with expense ratios starting at 0.2%.
“Impossible to see, the future is.”
Lastly, I have one more recommendation for all of you considering a 529 plan, and this is something I do personally:
Ask grandparents to contribute to your children’s 529 plan instead of overloading them with extreme amounts of toys and clothes.
The cost of college is rising at 6% OVER inflation (scary) and if that is to keep up, college is going to be very, very expensive. A four-year private college tuition (currently costs roughly $50,000/yr. to attend; $200,000 for a degree) will cost over $600,000 in 18 years! In state tuition and taking enough AP classes to pass out of 2 years of GE credits sounds like a great plan looking at the figures mentioned above!
So, I hope that this post helps explain some of the benefits of 529 plans.