With college costs continuing to climb, many parents worry about affording those staggering tuition bills. Many are turning to 529 plans to save more effectively for their kids' education.
The benefit of saving in a 529 plan is that the money you contribute gets to grow on a tax-free basis. Normally, when you invest money in a traditional brokerage account, any gains you realize along the way are taxable for the respective year they're taken. In other words, if your investments make money at some point in 2018, you'll need to pay taxes on those gains when you file your 2018 return. With a 529 plan, you don't pay taxes on investment gains at all, which can help boost your college savings. Not only that, but some states offer additional incentives like tax deductions or credits for contributing money to their respective plans.
The primary drawback associated with a 529 account is that you must use the money you save in it for educational purposes. It used to be that you could only withdraw funds for higher education, but recent tax code changes altered the rules so that private grade schooling is an eligible expense as well. If you use your money for other purposes, you'll risk a 10% penalty on whatever funds go toward a noneducational expense, but that 10% applies to the gains portion of your account only, and not your principal contributions.
The ideal time to open a 529 is early on in your child's life, because the longer you hold that account, the more opportunity you'll have to take advantage of the tax-free growth we talked about earlier. But what if your kids are already older -- say, high-school-aged? At that point, you'll really only have a few years to capitalize on that growth, and you'll probably need to be somewhat conservative in your investments since college is only a few years away. The question therefore becomes: Is it too late to open a 529 plan when your kids are older?
529s come in handy at different stages
It's true that you'll generally get the most value out of a 529 plan if you open it when your children are young. But if you've already missed that boat, these plans can still be helpful in amassing funds for college.
Imagine you have two kids in high school who are two and four years away from college, respectively. You realize you're behind on savings and want to start contributing funds to some sort of investment account to play catch-up. If you put your money into a traditional brokerage account and earn about $5,000 on your investments each year during your savings window, you'll pay taxes on that $5,000 gain year after year. But if you stick that money into a 529, you'll avoid taxes and get to reinvest your gains for additional growth.
Furthermore, if you live in a state that offers its own tax incentive for funding a 529, it could pay to do so for that break alone. And since college will only be a few years away at that point, you'll have an easier time estimating its costs, thereby reducing your risk of overfunding your 529.
One final thing: 529 plans allow you to switch between beneficiaries so that if, for example, your first child gets a scholarship to college, you can move funds in his or her name over to your second child. And if all of your kids get a free ride to college, you can find another beneficiary.
Saving for college once your kids are older is better than not saving at all. While your best bet is to open a 529 for your kids while they're young, there's nothing wrong with funding one when they're older, as you'll still get to reap whatever tax benefits you manage to eke out.
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