The Savings Conscious Parent's Primer on 529 Plans

by ParentCo. April 26, 2017

Want to send two children to a public 4-year college? That'll be about a half-million dollars. Private college tuition has been increasing at a rate of 4.5% per year. Public school tuition has been increasing at an even faster rate of 6.5%. According to one projection at Forbes based on those percentages, by 2030, one year at an elite school could average about $132,000. one year at a public 4-year college could average $73,000. Those price tags seem hopelessly expensive to parents of young children still balking at the cost of diaper bags, but by starting college savings before your child is out of diapers, you can turn relatively small savings into a tuition check.

What is a 529 plan?

The "529" in 529 plan refers to the tax code that permits these savings accounts. Don't let the name bore or intimidate you, because section 529 is incredibly valuable to parents trying to pay for college. That section of the tax code allows parents to invest money with no state or federal tax, as long as that money is used to pay for education.

Why should I invest in a 529 plan?

The first reason to invest in a 529 plan is the same reason you should save for any expense: compound interest. Starting early means your money has more time to grow before your children empty the nest. The second reason to invest in a 529 plan is that unlike other sorts of investments, you will not have to pay state or federal taxes on your gains so long as the account is used to pay for college or other qualifying educational expenses.

Does my state offer a 529 plan?

The majority of parents saving for college can find a 529 plan in their state. Two states (Washington and Wyoming) do not offer 529 savings plans.

Does my state offer a good 529 plan?

Although nearly all states offer 529 plans, not all plans are created equal. Forbes has a color-coded chart to help you decide whether or not to stick with your own state. That advice is based on two main factors: the fees associated with the savings plan and the state tax deduction for college savings contributions. If your state is green, then it has comparatively low fees and/or a sizable deduction for savings plan contributions. Yellow states may have high fees and/or low deductions. Red states offer no advantages for residents, who should comparison shop for the best plan in another state. To learn about plans in your state or to compare plans from different states, explore the 529 map at savingforcollege.com. If you live in a state with a strong 529 plan, there's little left to do but sign up for an account and set up recurring payments. If you're shopping for a plan, you might begin with savingforcollege.com's Top 10 performers of 2016 to see which plans might be bet for you.

How much money should I save?

Once you have opened a 529 plan, you'll need to decide how much to contribute to it. If the cost of public college tuition continues to rise at its current rate, only a rare few could pay out of pocket. With Forbes' estimated $73,000-a-year bill, it's safe to say that most parents won't be able to save enough money to pay for college in full. For example, if you are just starting to save and want to pay the full bill for 2030's projected average in-state tuition, Investor.gov's Savings Goal Calculator projects you'll need to save $292,000, which breaks down to monthly contributions of $1,324 for the next 13 years (assuming a 5% interest rate). That is an impossible savings scenario for many parents. It may not even be a desirable one. The question of how much to contribute is not a simple mathematical question. It's a philosophical one. Do you want to ensure your child emerges from college with no debt? Do you want to ensure that your child has reasonable monthly loan repayments that don't inhibit his/her future choices? Do you want to offer your child in-state tuition, expecting him/her to pay for the difference for a private or out-of-state school? Your answers to those questions can help you decide how much money to put into a savings account.

What are the tax incentives for saving in a 529 plan?

All parental philosophy aside, there are be some minimum amounts you may want to reach, because there are tax incentives for doing so. Indiana, Utah, and Vermont all offer tax credits for contributions to 529 plans, so parents saving in those states should attempt to max out their allowable contributions. In some states, the benefit of tax deductions for 529 contributions is relatively modest. In Ohio, for example, married parents filing jointly can deduct up to $2,000 per beneficiary per year. In other states, the tax deduction is much higher. New York allows $10,000. South Carolina has no limit on 529 plan deductions. These deductions and credits mean that you will have a future benefit (money for college) and a current benefit (lower tax bill) as a result of your savings. That's part of the reason it's important to review your own state's plan before enrolling in another state's plans. Generally, those deductions require that your 529 plan be from the same state in which you pay taxes. If you live in Arizona, Kansas, Maine, Missouri, or Pennsylvania, the world is your oyster. Those five states all allow income tax deductions for contributions to any 529 plan across the US, which means that parents in those five states can choose one of the highest-performing 529 plans and still receive a tax deduction for their contributions. There are two more conditions under which you may want to pick an out-of-state plan. If you live in a state with no income tax, you should feel free to shop around and pick the plan with the best return, as there is no particular incentive to stick with your own state. If you live in a state that has state income tax but does not allow deductions for 529 contributions (California, Delaware, Hawaii, Kentucky, Maine, Minnesota, New Hampshire, New Jersey, or North Carolina), you may also want to shop around to see what better plans are out there.

What if I don't have enough money to put into a 529 plan?

There's a perception that if you can't put thousands into a savings account, that account can't be valuable. Every little bit does help, especially if that little bit is consistently invested. Financial planners encourage young earners new to saving to smart small: skip just one latte per week. Skipping coffee may be a non-starter for you. Financial advisors making the latte recommendation probably weren't awake up all night with a baby before trying to navigate Target with a cart of hangry kids. The latte example can help you start to think about saving. Let's say you take those hangry kids to Target every week (a generous underestimate). If you spend $5 each time you pass the Dollar Spot (another generous underestimate), that's $260 per year. If you skip the Spot and instead deposit the money you would have spent into a 529 plan for 10 years at 5% interest, you'll end up with over $3,400. Keep going for 8 more years and you'll have over $7,600. Now imagine that same savings account got a good initial boost from a grandparent or auntie. If you open the account with $1,000 and make your Spot-less deposits for 18 years, you'll have over $10,000.

Can other family members make contributions to the account?

Many 529 plans make it easy for parents to grant electronic access to family members wishing to make a deposit. So whenever someone asks you what you need for your child, talk about the college fund. You might also consider making a preset plan about what to do with cash gifts to your infant or young child. How much goes to adorable-if-unpractical shoes and how much goes in the 529 account?

What if my child decides not to go to college?

The beauty of 529 plans is that, while they are designed for education, it doesn't have to be your child's education. If one child decides not to withdraw from the account, you can name another of your children, or an extended family member, as a beneficiary. You can even use the money for your own education. Let's say you're dreaming of going back to college once the kids are out of the house. You can pay for photography classes and, in some cases, the camera equipment, which can be counted as an eligible expense. Your child can also treat the 529 as a different kind of educational experience. If he wants to spend his 529 money backpacking Europe, or as seed money for his first business, the account will incur two types of penalties. First, you'll have to pay federal taxes on the income, as well as state taxes for any portion of the money you claimed a deduction on. You'll also have to pay up to 10% in withdrawal penalties. If your child can come to you with a travel plan or a business plan and explain how he'll absorb the financial penalties? That's an early-but-valuable financial lesson in cost-benefit analysis.

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