When you have a child you go through a life-changing experience (we recently brought our first into the world just a couple weeks ago). It brings joy and fear to you at the same time. You’re now responsible for another human’s life and they are wholly dependent on you to survive. It’s never too early to think about taking care of their future.
The future for most children will eventually include some sort of post-secondary school such as college. One of the best ways to save money for education is through the utilization of a 529 plan, you may see these labeled as Qualified Tuition Programs. These plans allow for tax free growth of investments to be utilized for paying for school. Previously this was for college only, but with the tax law changes in 2018 these can now be used for elementary, middle, and private school as well (This is limited to tuition only and $10,000 per year). Think of the 529 as a “Roth” for school for your child. There are certain restrictions such as you must name a beneficiary for the account and for all uses must be used for qualified expenses. College and universities have a bit of a wider scope for expenses that are allowable. These include:
- Fees (mandatory)
- Tuition
- Books
- Computers or peripheral equipment, computer software, or Internet access and related services (must be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible postsecondary school)
- Room and Board (This is only up to the greater of one of the following amounts)
A. The allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
B. The actual amount charged if the student is residing in housing owned or operated by the school.
Beneficiary
529 plans can also have their beneficiaries changed from one to another so in the event that you have two children and the first does not utilize all of the funds you can re-designate the remaining funds to another child with no tax consequences. 529 Plans are offered by each state but you are not restricted to utilize the state you reside in. There may be tax benefits though. While no federal tax benefits exist for 529 Plan participation, many states offer tax deductions. As of 2019 there are 34 states and the District of Columbia that offer tax benefits and they do change often so verify with an accountant that the tax law is accurate but these are the following states that offer state tax deductions.
Setting Up The Account
Most brokerage services like Vanguard, Fidelity, etc.. will offer 529 accounts and plans. Vanguard allows you to invest into a wide range of index portfolio with different risk levels.
States
- Alabama
- Arizona
- Arkansas
- Colorado
- Connecticut
- District of Columbia
- Georgia
- Idaho
- Illinois
- Indiana
- Iowa
- Kansas
- Louisiana
- Maryland
- Massachusetts
- Michigan
- Minnesota
- Mississippi
- Missouri
- Montana
- Nebraska
- New Mexico
- New York
- North Dakota
- Ohio
- Oklahoma
- Oregon
- Pennsylvania
- Rhode Island
- South Carolina
- Utah
- Vermont
- Virginia
- West Virginia
- Wisconsin
(Each state will vary with the amount deductible and you may want to provide tax diversification but spreading out contributions will effect the amount of compounding available)
If you’d like to here about it directly from the IRS you can check out this link.
The Power of Compounding.
Let’s take two different individuals for funding 529 plans. Both individuals will have $10,000 invested to for 20 years. Person A will be initially funded with the full $10,000 and will not have any contributions for the remainder of the account. Person B will start with $500 and $500 will be invested yearly for 20 years. Which will have more?
At the end of 20 years Option A will be left with $38,696.84 and Option B will have a balance of $23,867.43 (P.S. only putting in $7,000 initially would still bring the total to $27,087.79). Leverage your time to your advantage, if you are able to front-load the contributions then do so. It’ll pay itself off over time as it compounds. You can find a nifty compounding calculator here.
Time to Withdraw
As you get closer to withdrawal time it may be wise to adjust investment holdings to a more conservative approach (similar to as you get closer to retirement) to ensure you maintain investment growth and do not sacrifice too many investment gains. This can be done by moving a portion of the plan away from stocks and towards bonds or cash positions.
Penalties
If you withdraw from your 529 and don’t spend it on qualified expenses there may be penalties. You may be exempt though in certain cases. If your child receives certain scholarships, attendance to military universities, and other unforeseen circumstances you may be exempt. The best way to avoid these penalties is to ensure you are withdrawing from your account and using the funds on qualified expenses is to track the expenses and withdrawals and ensure you are doing it in the same calendar year. If you make a mistake the IRS will charge the distribution at your income level and place an additional 10% penalty on the distributions.
More Readings
If you’d like to read more about 529 Plans feel free to check out Morningstar or Joe over at Retireby40.
Thanks for reading!