529 savings plans are one of the most valuable tools available to families who want to save money to cover college expenses of their children or other loved ones. Unfortunately, a recent Edward Jones study found that nearly 70% of American adults have no idea what a 529 plan is. Here's a brief overview of the 529 savings plan and how it could help you plan for college expenses.
What is a 529 savings plan?
A 529 savings plan is a type of college saving investment account. They are run by the states, and while you aren't required to invest in your home state's plan, you may get some extra tax benefits for doing so, which I'll get to in a bit.
The basic idea of a 529 savings plan is simple. You contribute money to your account, and your contributions can be invested in a variety of mutual funds and/or automated investment portfolios you can choose, similar to a 401(k).
Now let's look at some of the advantages of a 529 savings plan, how much you can contribute, and how you should invest if you choose to use this vehicle for college savings.
Why not just invest through a regular brokerage account?
There are some clear advantages to investing through a 529 savings plan as opposed to simply investing in mutual funds through a standard brokerage account.
The tax advantages are the most obvious. 529 savings plans are treated similarly to Roth IRAs when it comes to taxation. Your investments are allowed to grow on a tax-deferred basis, and your withdrawals will be 100% tax-free, no matter how much profit your investments have made, as long as the proceeds are used for qualifying education expenses.
According to Marcos Cordero, CEO of Gradvisor, "If your goal is to save for college, a 529 plan is where you should put your money." And depending on where you live, there may be more tax advantages. "Over 30 states and the District of Columbia offer a tax deduction or credit on your contributions into a 529 plan. For example, the state of Illinois allows a couple filing jointly to deduct up to $20,000 from their state taxes," says Cordero. "These tax advantages could lead to thousands of dollars more for college." The website savingforcollege.com has an excellent directory of state plans you can use to compare your options.
In addition to the tax benefits, there are other advantages, such as automated age-appropriate portfolios, which invest more aggressively when the account's beneficiary is younger and become more conservative as they approach college age. I'll discuss these in more detail later in the article.
To be fair, there are some drawbacks to a 529 plan as well. If you don't use the money you save to pay for qualifying education expenses, you can be hit with a stiff penalty. And with a standard brokerage account, you could have a much wider variety of investment options to choose from.
How much can -- and should -- you save?
One of the big advantages of 529 savings plans as opposed to Coverdell ESAs or using a Roth IRA to save for college expenses is that the contribution limits are significantly higher. Most 529 savings plans will let you contribute as much as you'd like until your account reaches a certain balance – which is $400,000 or more in many cases and depends on your state of residence.
How much you should save depends on your situation. How much of your child's college education do you want to pay for? How much can you reasonably afford to set aside on a regular basis?
A 2016 Sallie Mae study showed that families pay about 30% of college costs, on average from their savings or income. However, this is somewhat misleading for our purposes since it includes families without 529 plans. Cordero advises that this is a good starting point, but to keep in mind that attempting to finance a certain percentage of a college degree can mean completely different things, depending on the school.
How should you invest your money?
I already mentioned the age-based investment options available in 529 plans. In addition, you may also have static portfolios (allocations that don't change over time), individual fund options, and more to choose from.
As Cordero points out, the majority of funds flowing into 529 plans today are invested in age-based options. These can be excellent choices if you want to make your college saving as simple, yet effective, as possible. "For example, an age-based option may contain 80% equities when the beneficiary is 2 and only 10% when they are 17," says Cordero.
On the other hand, if you have a bit more (or less) risk tolerance, or are a more sophisticated investor, you may want to create your own portfolio. Cordero says, "The investments you should choose really comes down to your risk tolerance and acumen as an investor."
The Foolish bottom line
A 529 plan can be a smart way to save for college expenses, and has some clear advantages over using a standard brokerage account. With a 529, you can grow your savings tax-free, and may even get some nice state tax incentives for your contributions.
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