College is becoming so expensive that even the country's wealthiest are struggling to afford it. But one reason why so many families resort to massive loans is that they don't save efficiently while their children are young. In fact, only 13% of those putting money away for college are utilizing a 529 plan, according to new data from Edward Jones, even though it's one of the most effective savings tools out there. Just as surprising is the fact that only one-third of Americans know what a 529 plan is. If you're clueless about 529s, here's a quick education that might get you to change your college savings strategy.
What is a 529 plan?
A 529 plan is a tax-advantaged savings plan designed to help families set aside funds for higher education purposes (though thanks to recent changes in the tax code, these plans can be used to pay for private education at the grade school level as well). Though the money you contribute to a 529 goes in on an after-tax basis, it gets to grow tax-free so that when you withdraw funds to pay for college, your ending balance is yours free and clear.
Benefits of a 529 plan
The great thing about 529 plans is that they offer a number of tax benefits. As mentioned above, you get tax-free growth on your earnings within your plan -- something traditional brokerage accounts don't offer. When you invest in a standard brokerage account and earn money year after year, you're required to pay taxes accordingly on your gains. With a 529, you're not paying those taxes year after year. In fact, you're not paying them at all. This means that if you invest $60,000 of your own money, and your investments allow that sum to grow to $120,000, you'll never pay taxes on that additional $60,000 provided you use it for qualified educational purposes.
Now, let's talk about investing, because that's something 529s allow you to do. By contrast, if you simply stick money in a bank account each month, you're going to see minimal growth, thanks to today's paltry interest rates. But with a 529 plan, you might easily see a 7% average annual return on your savings over time, which means that if you contribute $300 a month over 18 years, you'll wind up with $122,000. Put that same money in a savings account, and you'll come away with less than $70,000 when we factor in taxes and low interest rates.
Another advantage of 529s is that many states offer tax breaks for funding them. Generally, you'll need to save in your home state's plan to get a tax deduction out of the deal, but some states will give you that deduction for saving in any 529 plan. And a few states even offer a tax credit for putting money into a 529, which is not something you'll get with a savings or traditional brokerage account.
Drawbacks of a 529 plan
If there's one notable disadvantage to saving in a 529, it's that you're required to use that money for qualified education purposes. If you overfund your account, you'll face a 10% penalty on any amount you withdraw that doesn't go toward qualified expenses. However, that 10% penalty applies only to the gains portion of your account, and not the principal contributions you make. Furthermore, if you overfund a 529 plan but don't need the excess money immediately, you have the option to designate a new beneficiary on your plan who can then use those funds to pay for college, thus eliminating the penalty.
Another thing to consider is that some 529 plans charge considerable fees which can eat away at your earnings. Keep in mind, however, that you'll typically pay fees with a traditional brokerage account, too. Furthermore, in some scenarios, 529 plans can impact the extent to which your child qualifies for financial aid.
Is a 529 plan right for you?
If you're looking to save for college in the most effective manner possible, it pays to consider a 529 plan for the tax benefits alone. That said, there's another savings option that offers similar tax breaks: the Roth IRA. The only hiccups you'll face with a Roth are limits on annual contributions ($5,500 for adults under 50, and $6,500 for those 50 and over), and the fact that higher earners can't fund Roth accounts directly. But if these points aren't a concern for you, you'll get that same tax-free growth, only without the requirement to use your money for education purposes only. Otherwise, opening a 529 plan is a great way to grow your savings, score some tax-free gains, and, depending on where you live, possibly snag an additional tax deduction or credit along the way.