529 plans. You’ve been hearing about them since your first child was born. You’ve put off opening them nearly as long. And now the day has come. It’s time to seriously consider whether or not to open a 529 for your kid.
But… what if the correct answer is: not?
What is a 529 plan?
Let’s first refresh our memories as to just exactly what a 529 plan is.
Basically, it’s a savings plan similar to a 401(k). Except in a 529, you save money that you will later use to pay for your kid’s college, instead of for your own retirement. As with 410(k) savings, 529 plan savings grow tax-free until they’re withdrawn and used to pay for qualified education expenses. Unlike with a 401(k), though, withdrawals from a 529 are also tax-free (again, so long as you use the money to pay for qualified education expenses).
Qualified education expenses can include tuition, of course, but also room and board, textbooks, school fees, and anything else that you can reasonably argue is an education expense. You can even use 529 money to pay for K-12 expenses.
Sound good so far? Okay. But before opening a 529 plan, there are still a few questions to consider:
Is your 529 a college savings plan or a prepaid tuition plan?
529 plans come in two flavors: Savings plans and prepaid tuition plans. In general, I prefer the former, because they let you use your savings to pay for any college (or pre-college) anywhere in the U.S. — and even outside the U.S.
In contrast, a prepaid tuition 529 plan is just what it sounds like. Instead of “saving” money to pay tuition “tomorrow” (at tomorrow’s rates), you prepay the cost of tuition today, at whatever your target college charges for tuition today. But payments made to a 529 prepaid tuition plan usually lock you into a single state’s public university system.
If you live in New York, and worry your kid might end up going to college in sunny Florida, a prepaid tuition 529 might not be the right choice for you.
Will your kid even go to college?
College isn’t the right choice for every kid (and even when it is the right choice, there’s no guarantee she will choose it!) Before setting up a 529 plan, plan for what you will do if your kid does not, in fact, end up going to college.
For example, you can still get the money back (yes, even in a prepaid plan), but you may incur penalties. Specifically, you’ll have to pay taxes on the withdrawal as if it were ordinary income (which it kind of is, since you didn’t end up spending it on education). Plus, you’ll have to pay a 10% penalty on money withdrawn.
Even after taxes and penalties, though, you might still end up with a profit if the investment performs well, and grows tax-free for years before you withdraw it. So this is more of a “you didn’t get as much as you hoped you would get” situation, rather than “oops, all your money is gone now” situation.
How soon will your kid go to college?
529 plans are best suited for long-term investing, as your investments grow tax free over time. If your kid is off to college in the next year or three, it may not be worth the hassle. This question is especially pertinent for parents wanting to use 529 plans for K-12 savings.
It might not make sense to save money in a 529 plan this year, if you’re just going to take it back out and spend it on kindergarten next year.
Does your state have lousy 529 options?
A 529 plan is a little like a mutual fund, in that it may charge high fees, or be run by poor money managers. If your state doesn’t have good 529 options… find better options.
Also consider state tax benefits, or lack thereof. For federal income tax purposes, 529 contributions are made with after-tax dollars. The state sponsoring your 529 plan, however, may allow you to deduct contributions from your state taxable income. Or it may not.
In the best possible world, your state may give you an actual tax credit for contributions. In Indiana, for example, parents can contribute up to $7,500 per year to a 529 plan, and receive a tax credit of 20% of that amount. That’s $1,500 per year in free money!
For me, opening a 529 plan for my very young children was the right thing to do. Your situation, however, may differ.
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