Personal Finance 101: What Is a 529?

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pf101Fairly regularly on The Simple Dollar, I mention that I’m investing in 529 college savings plans for my two children. Each month, I automatically contribute $100 to each of their plans – and I’ve considered contributing more than that.

But what’s a 529? Erin writes in with a typical query:

You write all the time about saving for your kids college education in a 529. What is that? How do you do it?

Let’s dig in.

What Is a 529?
A 529 plan is simply an investment account with a few tax advantages that make it very useful for saving for higher education. To be specific, any interest or investment income earned in the account that is then used for higher education is exempt from federal taxes (and from state taxes in many locations). In some states, the contributions themselves are deductible from state taxes.

There are two types of 529 accounts: prepaid accounts and savings accounts. Prepaid accounts are used to purchase tuition “credits” at certain institutions at current rates, so, for example, you might be able to purchase a semester’s worth of tuition at East Overshoe Tech at the current rate of $10,000 a semester, but in fifteen years when your child is actually attending the school, tuition might cost $20,000 but you won’t pay a dime – you’ve already purchased that semester.

On the other hand, savings accounts are basically just investment accounts – you contribute money, it goes into the stock market or into bonds, and any gains you earn stay within the account. When the account’s beneficiary goes to college, the money can be used at any school. In other words, savings-style 529s are more flexible, but they often don’t return quite as well (since higher education tuition growth is usually greater than the stock market).

Most states have their own 529 plans with specific rules; however, many states have plans that are open to people from other states to contribute.

Another important aspect of 529 plans is that the beneficiary does not control the account – the person that opens the account controls the money. This is a great protection, as it keeps overzealous children from “cashing in” on their college savings.

How Do I Do It?
My investments go through College Savings Iowa. This offers me a number of specific benefits.

First, as an Iowa resident, my contributions to my children’s plans are deductible from state income taxes. Largely because of these contributions, we received a refund on our state taxes this year, while we had to pay in a small amount on our federal taxes.

Second, College Savings Iowa uses Vanguard to manage their investments, and Vanguard is a company I already trust with my retirement savings and other investments. The plan offers quite a few stellar investment choices – I’m currently using the “aggressive” target investing plan for both of my children, which is a low-cost collection of index funds that strive to earn large returns.

Third, the plan is tied in directly with Upromise. Once I signed up with this program, a small percentage of our credit card usage goes straight into those 529 accounts. It’s usually a small amount each month, but this money is essentially an additional free contribution to my children’s college savings plans.

How Do I Sign Up?
First, you need to decide which plan to use. Most states offer their own 529 plans, but they all vary quite a bit. You should start by seriously considering the plan in your own state, because many state plans offer income tax breaks for state residents – you can find your own state’s plan by Googling your state’s name and 529.

If your own state doesn’t offer a plan or only offers a plan you don’t like (such as a 529 that only allows prepayment of tuition to universities you don’t like), look at plans available in other states. Liz Pulliam Weston at MSN MoneyCentral has identified five great state plans, for starters.

Once you’ve signed up, you’ll set up an automatic investment plan that draws whatever amount you specify each week or month from your checking account and puts it away for your children’s education (or your grandchildren’s education … or your own). It’s quite easy, and it’s a great way to get started with college savings.

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36 thoughts on “Personal Finance 101: What Is a 529?

  1. Also 529′s are counted as parents assets (not kids) for college aid. If your child decides not to go to school you can change the beneficiary to another family member. I also use College Savings Iowa (though I live in RI). The other plus of this and many 529′s is that they offer age based plans (so the investments get more conservative as your child gets closer to college age).

  2. You can even set one up for yourself if you don’t have kids and transfer it later on. 529s are a great, tax-efficient way to save for college. Not enough people take advantage of them.

  3. Excellent introduction to the topic.

    To anybody considering opening a 529, be sure to take the time to find out whether or not contributions are deductible in your state and what your state tax bracket actually is.

    If contributions aren’t deductible where you live, then there’s hardly any reason not to shop around to find a state with a good plan.

  4. Thanks for this. Our first child is expected in less than a month, and opening a 529 plan is high on my list of things to do. This will make the task a little less daunting!

  5. What happens if you save enough money for your child to attend a private school, but they end up going to a public school, which is a lot cheaper. What happens to the extra money in the account? Is it taxable at that point? And who gets the money, the parents or the kid?

  6. Similar to Melissa’s question above, what if you buy prepaid credits and your child doesn’t get in to that school?

  7. As I understand 529 plans there is a penalty for removing it for non-qualified expense plus the tax owed, but you can change beneficiaries any time. So it can be send to college money. If your children don’t use it ever maybe grandchildren, maybe nephews, nieces or just use it yourself to study botany and underwater basket weaving. Also this covers school related expenses (ones that are normally tax deductions) like books, room and board, association fees and the like.

  8. Melissa (#5) and Marc (#6), the questions you raise are why my wife and I decided that we’d rather keep our kids’ savings in our name… while it creates a tax liability for us, it achieves two things which outweigh that liability (at least for us): greater freedom & control over the the savings. We and other family members want our kids to have this money available to them when they become adults, but we want it to be able to be used for any (good) reason, not locked in to college expenses.

  9. If the beneficiary, say kid #1, doesn’t use all the money for college, you can change beneficiaries to say kid #2.

    You can also change the beneficiary to yourself if you want to go back to school. It’s pretty flexible.

    If there’s any leftover after that, you can take it out, but you’ll pay tax on the account earnings, as well as state tax on the original contributions if they were deducted when made.

    One thing Trent didn’t mention is that normally the investment can only be changed once a year. (For 2009, there is a provision that you can do it twice, but I’m pretty certain that is only a one-time thing). Some people may find that too restrictive.

  10. Thank you so much for this post.
    I’m a young professional trying to think ahead for my kids in the future and the 529 is a great way to save. You can open an account for $25 and never contribute to it again. No pain. The only fee that it has is a 0.55% management fee.
    The 529 people in New York were VERY helpful and nice.

  11. @Marc #6

    Prepaid in Washington state is figured as 100 units being equal to buying a years worth of college at “the most expensive school in the state” given current prices. When they pay out, 100 units are worth a year at the most expensive school in the state then. You can use the units where ever your student may go, and can transfer the excess to another account (child number 2) or take a cash disbursement.

  12. We decided not to open an education account in case he doesn’t go to college. I have no idea what his plans will be, but we will help him pay for college if he does attend. We can pull the money out for college from our Roth IRA’s and no taxes. He also has a trust fund in his name which won’t be touched. It will be a great chunk of change when he’s an adult.

  13. What happens if I start a 529 now and then subsequently move to a new state? Can I withdraw the $$ from my child’s current 529 after only a few years and then start a new 529 in a different state, without any penalties or fees?

  14. I was wondering, if someone were planning to go to college after say 5 years, would it be beneficial to use something like this to start saving or would the return/benefit be too negligible?

  15. Not necessarily true, Thrifty Momma! As I understand it, if your withdrawals exceed your lifetime contributions, the excess will be taxable even if used to pay for higher education expenses. In other words, earnings on Roth IRA contributions effectively are not distributed tax-free for higher education expenses. However, since the rule is “contributions out first,” if you can manage to spend only your contributions and hang onto the growth until retirement, then you can get the distributions tax-free as you normally would.

    So, how likely is that to happen? Tuition, room, and board at top schools is already nearly at $50K/yr. Even assuming that this cost increases only at the rate of inflation (which historically hasn’t been true at all), your total joint contributions to a Roth IRA for the kid’s entire pre-college life won’t cover the cost by itself (~$200K vs. ~$180K). And, you know, that’s assuming you have complete alternate funding for your retirement.

    Also, if your kid doesn’t go to college, then the Roth IRA money can’t be used to fund his alternative endeavors without paying the usual penalties and taxes, so in that sense it’s no better than a 529 when it comes to supporting him. Yes, Roth IRA money can be used for your retirement if he doesn’t go to college, at all, ever. It is definitely more flexible in that sense. But since you can change beneficiaries on the 529, that money can go to your grandkids, your nieces…whoever.

    I’m not convinced the Roth IRA is that great an alternate vehicle for college savings unless your retirement is entirely funded from elsewhere and you think your kid almost certainly won’t go to college or have kids himself (which I suppose could be the case for some special-needs kids).

  16. I think the Roth IRA is an excellent alternative to a 529 because it offers more flexibility. I’ve been maxing out mine and my husband’s Roth IRAs since several years before my kids were born and will be able to take out the full amount I contributed, tax and penalty free, when my kids need help funding college or for anything else they need help with if they don’t end up going to college. We plan to cover our retirement needs from other sources (social security, our government pensions and 401ks) so anything left in the Roths after our 2 daughters are educated will be just a bonus for us. Granted, not everyone will have access to pensions and 401ks, but if you can fund retirement from other sources, I think Roth IRA contributions could be a good alternative to 529s for paying for the kids college expenses.

  17. Also, and I could be wrong about this, I don’t think the parents’ retirement accounts are taken into account with financial aid formulas so that would be another advantage for the Roth over the 529.

  18. I’m a 529 beneficiary, and it has helped me out SO much. I would have gotten free tuition at an Illinois state school, but I’m at a private school now. My dad paid 1997 admission prices for me to attend 2007-2011. It’s actually cheaper to go to a private school with the scholarships I got (plus, I didn’t like U of IL).

    One word of caution – if you attend out of state/private, College IL pays by the credit hour. Full time is 12-18 credit hours, with 15 as the average. So, they assume one year equivalent tuition for private schools is 30 credit hours. I’m getting out in three years and am taking 18 credit hours a semester, but may end up using up a four year policy anyway.

  19. Maybe I’m missing something, but if you already have your retirement covered from elsewhere, then why not just put the money in an ordinary investment account? Getting to “take out the full amount I contributed, tax and penalty free” is meaningless–you’ve already paid taxes on that amount, so you could accomplish that by sticking the money under the mattress. Meanwhile, the withdrawal of earnings from a Roth for that purpose will be taxed as ordinary income, whereas it should be fairly easy to arrange that the bulk of the earnings in an investment account are taxed as long-term capital gains. And, of course, you have the ultimate flexibility to use the money exactly how you choose.

    The parental assets/financial aid point might be a good one, except that if you’re actually on track to retire without any reliance on 401(k)s, you are probably earning too much for much financial aid, anyway. But that’s more complicated to know and probably varies a lot based on individual situations.

    Finally, “or for anything else they need help with if they don’t end up going to college”–I don’t think that’s right. I don’t see any general exemption from penalties in there for people just helping their kids travel round the world or start a business or whatever.

  20. my question is, when you start saving in this and your child decides not to go to college, can you still get to it? what happens then?

  21. What happens when you pcik the plan for a certain school prepaid and your kid cant get in to that school / wont go to that school? What is set up for this situation?

  22. If you happen to be of a certain age, a Roth can be a good option, offering more flexibility. Specifically, if you will be of retirement age when you kid goes to college you have more latitude. Sadly, I am in that group. : (

  23. I’ve been meaning to set up college funds for my boys. I looked into it when I was pregnant with the first, and researched it like crazy, and then he was born – fast forward 4 years later and I haven’t done it. Things tend to come up. LOL

    I’ll have to look into this option. thanks for the info.

  24. One option left out of this discussion has been the Coverdell Education Savings Account (ESA). While you can only put up to $2000 in per year per child, you have more control over where the money is invested. It has the same tax advantages of the 529s. There are some differences in that with the ESA, you can use the money toward private school (elementary, middle, high school) and not just college. Drawback is the money has to go to the student by age 30, but it can be transferred to another family member. I personally think it’s a good idea to put the first $2000 into an ESA before contributing it to a 529. And if you are saving more than $2000 per year, then use the 529. I like having more control over how my money is invested.

  25. I am mom to a 2 year old in TX – the state just reopened the Texas tomorrow fund…I went to the website to check it out and was very very HORRIFIED by the terms/conditions/assumptions of this plan. Yes, you’re buying credits – but texas has one of the cheapest higher ed systems – and they want me to buy $600 per month worth of credits for 16 years…and they estimate such a low rate of return//high tuition cost in the future, I’d be earning more interest with CDs! I know you’re actually hedging against tuition increases in lieu of interest but still – that $600 independently invested and conservatively estimated at 5% return over the same period is $178K. I’m currently saving about $200/month in a combination of plans (we have a 529 and a Roth, since Daddy will be *ahem* eligible for distributions concurrent with college) and hope to bump that up when my non-mortgage debt is gone…In addition to the math that just doesn’t seem to work, I also want my daughter to have more options than just Ut, A&M, Texas Tech. I lived in VA and I may be a snob, but I don’t think the TX options can compare to Virginia’s flagship public universities: WIlliam & Mary, Va Tech and UVA. I won’t tell you which one I went to!

  26. I have a 11 month old son, and I investigated 529 plans and decided against it. They might not remain tax free (it’s up for debate again in 2010 and probably many more times before my son reaches college), and I imagine it will really affect a child’s financial aid. Count me in the Roth IRA camp. Sure, you can only withdraw the contributions and not the earnings tax free, but it’s a start. You could combine that with other investment accounts that are not earmarked for education.

    In general, I am frustrated by how the FAFSA system penalizes parents for saving and being frugal. I went to an expensive private school, and my father didn’t make that much money. But because he was a saver, we ended up having to shoulder the entire tuition and living expenses. I had friends whose parents made far more than mine that received financial aid.

  27. I have 11 years before he graduates high school. We are debt free including a paid for house. More than likely we will just cash flow his education expenses. But if we need to dip into the Roth then we can. We max each one so we will have more than enough to avoid taxes. I also don’t plan on taking out more than we funded. Since we only have one child, this is what will work for us. I do think everyone should look into all their options before making a decision. Financial decisions aren’t a one size fits all.

  28. If it was my kid and s/he was not willing to go to the school for which we had prepaid tuition, s/he would be going to college on their own dime! Bottom line for college is that it doesn’t really matter where you graduated from, for the most part. The factor in future success is the effort the student puts in.

    Didn’t get in is another issue.

  29. “529″ is a farm-to-market road in Northwest Houston that runs westward all the way to Bellville, Texas.

    (Thanks, I’ll be here all week. Try the veal!)

    We plan on having kids, but since we don’t yet we’re just putting what we call “college money” into a Sharebuilder account every month.

  30. @jane: If Grandparent(s) set up 529 for grandkid(s), there is no impact on FAFSA. I would think parents should primarily focus and maximize 401K and Roth IRA, shelter as much as for themselves. I just don’t think 529 is flexible enough, given the uncertainty of many factors-how about job security & relocation?

    Yes, it’s true you can change beneficiary. I would rather leave the option open as @Thrifty Momma.

  31. Another good article on 529.
    I’ve a thought about this for long. Please comment on this strategy. I will open 3 529 accounts for my kid, wife and myself one for each and save the tax on contributions (3 * $750) on all three accounts. If my wife and I decided not to attend any college then we can make my kid as beneficiary on remaining 2. This way he will have good money for his college.

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