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· 6 min read
Contextualizing the finance news you need to know.
I saw the cutest baby at the park the other day, drooling and babbling nonsensically on a picnic blanket while sporting a…Yale onesie. ? Maybe his caregivers went there and are the proudest Bulldogs around. Or maybe, just maybe, their six-month-old’s college plans are already top of mind. That’s a lot of pressure for a li’l nugget still working on the intricacies of sitting upright.
But to be honest, I kind of get what they’re doing. College has become so expensive that many adults hoping to help a child they know or love avoid the burden of student loan debt begin saving long before the child can walk. And the holy grail of financial vehicles here is the 529 college savings plan.
Established in 1994, it’s undeniable that the 529 savings plan has consistently gained popularity over the years. But is it really the best way to save for a child’s education?
What exactly are the benefits of a college savings plan? Funds invested through 529 plans can grow without owing capital gains taxes (similar to a Roth IRA) as long as those funds are used to pay for qualified education expenses. (Besides college, up to $10,000 can be used for education expenses like K–12 schooling or paying off student loans.) Over 30 states offer state tax deductions to their residents for contributions to a 529 plan, with varying limits, but funds invested into these plans are not federally deductible.
Oh, and 529 plans are also easily transferable among eligible family members. This means you can transfer the plan to a different beneficiary if the original beneficiary graduated or left school without spending the full amount (or skipped post-secondary schooling altogether).
Some people even open a 529 in their own name first and then transfer the account to a child after they’re born, without incurring any fees. Plus, all 529 accounts accept third-party contributions, and you can designate anybody—including a nonrelative—as the beneficiary.
Note that you’re not limited to the 529 plans available in your state, so do your research to find what plan has fees and investment options that work best for you. Certified financial planner (CFP) Eric Roberge recommended searching for plans that offer lower fees and more competitive mutual funds or investment options. “You really want to pay attention to the total cost and availability of investment choices inside of the 529 plans that you might choose, and then also the specific tax benefits of your state program,” Roberage told Money Scoop.
Another factor to consider is strategically diversifying your asset allocation with education savings in mind. A 529 plan offers age-based portfolios to minimize risk as your beneficiary approaches their target educational endeavor. This becomes especially important when the stock market is being extra chaotic. Because you really don’t want most of your long-term savings invested in depreciating stocks when the first tuition bill comes.
The downside to 529 accounts is their lack of flexibility. Seriously, though, they’re as stiff as Karate Kid’s antagonist sensei trying to bust a move: You can’t withdraw funds for noneducation or unqualified education expenses without incurring a 10% penalty plus income tax on your gains (yikes). And your investment options are pretty limited (sorry, no meme stocks allowed).
Also, unless you’re rich—like you own over $12.06 million in assets rich—or you want to scooch down from a higher tax bracket, be aware that the tax benefits you get from a 529 account can be pretty tiny.
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I know that $12.06 million sounds pretty random, but it isn’t. It all has to do with federal estate taxes. So what that means is, by 2022 rules, anything above that sum left in your hypothetical moneybags estate would be taxed at a whopping 40% (after you die, of course). But if you have a 529, you can gift as much as $16,000 a year to a 529 beneficiary (while you’re alive and kickin’) and count that money toward an annual gift tax exclusion.
In other words, Richie Rich’s dad was probably funneling a pretty penny into a 529 every year since before the kid was born as a way to pass down wealth tax-free. So while there’s no doubt a 529 can be useful, it’s only really useful to a specific demographic. ?
Let’s go back to the 99%. Pamela Capalad, CFP and founder of Brunch & Budget, shared an example case of one client who would’ve saved about $600 in state tax deductions after investing $10,000 in a New York 529 account—and of course her investments would also grow tax-free.
That’s some solid extra cash, but for many it’s not worth locking a significant portion of an inheritance into education with limited investment growth or giving up on savings the contributor might need in an emergency.
“We don’t recommend them for most people anymore,” said Samantha Gorelick, CFP and managing financial planner at Brunch & Budget. “It’s kind of rare that it’s the best option for folks. If you look at the numbers, the tax savings are not significant.”
Financial planners disagree on whether opening a 529 account is a good idea, given the limits they impose on how you can invest and spend your money. But the general consensus is that they’re not the most powerful tool out there, and the benefits only go so far. “They’re nice, but I really don’t think it’s going to make or break someone’s situation,” said Roberge.
But with mounting education fees and kids apparently being indoctrinated to their caregivers’ (expensive) alma maters at the tender age of zero, what other tools are available?
Gorelick told Money Scoop that going back to basics and sticking with high-yield savings accounts, investing conservatively in a taxable brokerage account, or relying on I bonds are better ways to save for education—and they’re much more flexible. Better yet, if someone besides the beneficiary’s parents wanted to pitch in to the cause, they could open a custodial brokerage account under the beneficiary’s name.
I bonds offer tax-free growth and help counter inflation (and have been hoarding headlines with today’s rate standing at a record 9.62%). You can purchase up to $15,000 each year ($10,000 electronically and $5,000 in paper) per SSN, so those two Yale-loving grown-ups could purchase $45,000 in I bonds a year using their SSNs and the baby’s SSN. That’s a nice sum earning tax-free growth, and it’ll stay safe and sound until it’s time to pay for that first tuition bill.
So, (*deep breath*) unless you’re a high earner who: a) is 100% sure your beneficiary will continue their education at some point, b) has sturdy-enough savings and alternative investments to not need 529 funds for emergencies, and c) has sufficiently funded your retirement already, then it might be worth exploring other options. In this case, it’s really worth doing your homework. ?—Isabel
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