Pros and Cons of the 529 College Savings Plan

In this video from the Motley Fool Answers podcast, Alison Southwick and Robert Brokamp welcome Sean Gates to the show as they answer listener questions.

This latest question will be of interest to any parents or future parents who think their kids might one day head to college. The team hashes out the pros and cons of funneling cash into a tax-advantaged college savings plan for your child, rather than paying for tuition straight out of the old brokerage account or your cash reserves.

A full transcript follows the video.

This podcast was recorded on Dec. 13, 2016.

Alison Southwick: The next question comes to us from Lindsey in Arlington, Virginia. Someone else just down the road. "Thanks for all the personal finance advice via your podcast. I just had a baby, so of course I'm already thinking about saving for college. However, I'm still confused about the benefits of a 529 plan. My husband and I have approximately $200,000 in non-retirement investments as we started following The Motley Fool when we were in our early 20s." Oh! "We're in our mid-30s now. Should we start a 529 plan, or just keep investing and pull his future college fund out of our investments? We are well on track with our retirement savings and have a ten-month cash emergency fund."

Sean Gates: Boom!

Southwick: Yeah!

Robert Brokamp: Very impressive.

Southwick: We are most impressed!

Brokamp: We are most impressed!

Gates: I don't even have a 10-month cash reserve.

Brokamp: So 529 plans are so named after its section in the IRS tax code, 529. They're sponsored by states, often operated by financial services companies. And the benefit is that you put the money in, and it grows tax-free as long as the money is eventually used for qualified higher education expenses like tuition, room and board, and a few other expenses that you can use. It has to be a qualified university. It can't be -- I don't know -- some crazy place in the Bahamas. Something like that.

And one of the other benefits is, since you live in Virginia and I participate in Virginia's 529 plan as well, is the money that you put in can be deducted from the state income tax return as long as you participate in Virginia's plan. But you don't have to participate in your own state's plan. You can look for a better plan if your state's plan isn't very good. The best source of information about that is Savingforcollege.com. It rates all the plans so you can see whether your state offers a break and whether it's worth staying in your state.

So I would say 529s are a good idea. I have it for my kids, but they're not the only things out there. What's your take on 529s?

Gates: I think 529s are a great option. One of the other things that people, I think, get stuck on is what happens if their kid is a bum and they don't go to school and they can't use that money. Well, one of the nice things about a 529 is you can continually roll it to additional family members. So if you have multiple kids, and the first one's a bum, [that's a] bummer...

Southwick: Many successful people didn't go to college.

Gates: That's true.

Brokamp: That's right, or a self-starter, or an entrepreneur.

Southwick: Or an entrepreneur.

Brokamp: Right.

Gates: And that's a very fair point.

Southwick: Doesn't even need the money.

Brokamp: Right.

Southwick: Mom, thanks for the 529, but I already bought my Tesla, and my little start-up is doing fine, thank you.

Gates: The point of the story is most kids are bums.

Southwick: Oh, ho, ho.

Gates: So if the first kid is a tech genius and doesn't go to college, you can give it to the second child and they can use it. So eventually, it's pretty easy to use it up if you have multiple kids. You can also transfer it from yourself, actually. I know a couple of folks who have started a 529 for themselves early, before they even ever had kids, and then transferred it to their child to get a jump-start on savings for college.

Brokamp: Yes.

Gates: So there's a lot of flexibility in there.

Brokamp: One of the drawbacks for some people to a 529 is that you can only invest in mutual funds. And for people who really want to save for college and invest in individual stocks and are looking for a tax-advantaged account, there is the Coverdell Education Savings Account. It has a low contribution amount. You can only contribute $2,000 a year, but that's still nice.

There are income limits, so if you have an adjusted gross income of $110,000 if you're single and $220,000 if you're married, you're supposedly not allowed to contribute to it, but all you do, then, is just give the money to the kid and they contribute to the account themselves. And in that not only can you buy just about anything you can normally buy at a brokerage account, the money can also be used for qualified education expenses for a private elementary or secondary school. So it has a little bit more flexibility. It does have to be used up by the time the kid is 30, however.

Gates: And just a couple of additional gotchas. I think Bro's website is definitely one of the better resources to follow, but reciprocity is one thing that exists for a lot of these accounts, especially 529s, so if you're in Virginia, and you participate in the D.C. plan, you might still be able to claim that state tax deduction. So there's a couple of different areas where you don't have to use your state's 529 if you find a better alternative, as Bro mentioned.

And the final thing is you just want to make sure that how you classify your assets (parents versus grandparents versus the child's) is all sort of aligned when you go to file for FAFSA, so utilizing the various buckets that you have had saved makes a material impact on their ability to get education loans assuming that you haven't fully funded it via the 529.

Brokamp: Right.

Southwick: So you're looking way down the road.

Gates: Yeah.

Brokamp: Yeah. And FAFSA is the form you fill out to determine how much aid you're eligible for and definitely, the worst situation is for the kid to own the asset. And there are some great calculators out there called EFC calculators (basically expected family contributions) that will give you a rough estimate of how much aid you might be eligible for anyhow.