529 Savings Accounts: How to Save Money for College the Smart Way

Do you and your spouse agree on how much you'll pay for your children's college? There are different philosophies on how much to pay — and who foots the increasingly steep bill for higher education. If you're not sure where you stand, read My Kid's College Will Cost How Much? Four Critical Questions About Your Saving Strategy.

I previously shared three college funding strategies: self-sufficient (student pays all), state school (parents pay up to the cost of state college or moderately priced private college with merit aid), and it's our pleasure (parents pay all). 

For this article, let's go with the state school scenario, where a couple agrees to fund a state school at $25,000-$30,000; if their children select a more expensive private college or university, the child will pay the difference. So Julia and Miguel are in it for at least the cost of state college and need to implement a saving strategy. Where should they start? 

That's easy. Open a 529 account for each of their children.

What is a 529 plan?

A 529 is a tax-advantaged savings plan established by individual states to help families save for higher education expenses. Each state partners with an investment provider to offer the investment vehicles available within the plan.

States make the mechanics of opening and funding a 529 account easy. All you need is for the child to have a Social Security number. 

Why use a 529 for college savings?

Similar to the favorable tax treatment given to retirement accounts, tax-advantaged 529s are designed to help with funding college. The tax treatment of 529 accounts is the same as for Roth accounts: After-tax money is contributed, and any gains are tax-free as long as used for qualified education expenses (more on the definition of that term to follow). Another important feature of 529 plans is that the owner of the plan, the parent or grandparent who sets up the account, retains control of the funds and how they are spent. 

Let's say you deposited $10,000 in your 529 account the year your child was born (good for you for thinking ahead!). By the time they enter college at age 18, your initial deposit may have grown to $30,000, a gain of $20,000. Not bad. 

If you had chosen to invest this money in an investment account, you would owe $3000 or $4000 (depending on your income tax bracket) in federal capital gains taxes. Depending on your state of residence, you may also be paying state taxes on the gain. 

What is the definition of qualified education expenses?

To get this favorable tax treatment, the money in a 529 account must be spent on "qualified education expenses." Here's a partial list of allowable expenses:

• Tuition and fees

• Books and supplies

• Computers and internet access

• Room and board (on-campus or the equivalent amount for off-campus living arrangement)

• Special-needs equipment

• Student loan payments up to a lifetime limit of $10,000

Do I need to use my own state's 529 plan?

No. Although each state has set up its own 529 plan, you aren't limited to your home state's plan. For example, you may live in California but choose to use the Utah 529 plan, even if Junior plans to attend Florida State. That's why it's important to look around. Your goal is to let the money grow in the long run, so study up and choose a plan with lower expenses and better investment results. 

Even though you aren't limited to your state's 529 plan, there may be an added benefit to using your home state's plan. Many states offer income tax incentives for state residents. This is true for my home state of Minnesota, where state residents are eligible for a tax deduction or tax credit for any state's plan they choose. However, other states, like New York, allow the tax benefit only if you use your home state's plan.

Don't like the state plan you initially selected? No problem. You can change which plan you are using once a year.

How can I best invest the money?

I favor target-date funds, which many state plans offer. The investments in these accounts are allocated by the firm offering the plan, so the account owner doesn't need to be involved. When the children are young, the allocation is aggressive — mostly in stocks — to grow the balance. Over time, investments automatically become more conservative, with an increasing allocation to bonds. 

By the time Junior enters college, the accounts are often allocated 100% to bonds. This way, you won't be risking a dramatic decline in account value just when you need the money.

For those whose income might allow them to qualify for need-based financial aid, a 529 account can have a small negative impact on the amount of aid the child qualifies for. The impact is negligible, especially when compared with the benefit of long-term tax-free growth the 529 allows.

Are you scared off by the rules and restrictions?

Don't be scared! What's the worst that could happen? That you are not able to spend all the money in the 529 account on qualified education expenses. It's not as bad as you imagine. More on this below. 

In the past several months, I have spoken with two physicians who are DIY investors. They're doing a great job of handling their finances. But both had one significant gap in their financial plan: Neither were funding 529 accounts for their children. The reason? They were hung up on the details, specifically about overfunding and having money left over that would be subject to tax and penalty. 

The story above is a perfect example of "analysis paralysis." Just think about it for a second. Given the cost of college and graduate school, overfunding is unlikely to be your problem. The more likely scenario (by far) would be not having enough money in your 529 account to fully fund college. 

What if I overfund my 529 account?

In the unlikely event you end up with an overfunded 529 account what are your options?

• Use it to pay for graduate school.

• Transfer it to another one of your children (or another relative).

• There's no spending deadline, so hold onto the money, let it grow, and help your grandkids pay for college.

• Make yourself the beneficiary of the 529 and use it for continuing education courses at an eligible higher education institution.

What if I don't spend unused 529 money on education?

If you end up using 529 funds for non-qualified education expenses, the damage is not as bad as you might think.

Let’s go back to the earlier example where $10,000 grew to $30,000. The earnings portion of the non-qualified withdrawal will be subject to income tax and a 10% penalty. If the withdrawal is paid to your child, the gain of $20,000 will be taxed as ordinary income at your child’s tax rate, which is likely to be lower than your tax rate and possibly 0%. In some situations, the 10% penalty is waived, such as if your child becomes disabled or if they receive a tax-free scholarship.

How can you avoid overfunding your 529?

So what's the solution? We usually have our clients accumulate 3-3.5 years of expected college expenses in their 529 account. At about age 16, we switch any additional contributions needed into an investment or bank account. 

There's not as much benefit to adding new money to a 529 account for older children; there probably won't be much additional growth that will be tax-free. Plus, money held in a bank or investment account is flexible and not subject to the onerous rules of a 529 account. Unlike the restrictions on how you spend money in your 529 account, if you end up having any extra money in the bank or investment you can spend it on — without penalty. 

Don't miss out on this great opportunity

Worried about funding college for your children? That's understandable. The sooner you start funding a 529 account, the better chance you'll have of meeting this financial goal.

Disclaimer: The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that a college-funding goal will be met. In order to be federally tax-free, earnings must be used to pay for qualified higher education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient's marginal rate and subject to a 10% penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.

The above article is intended for informational purposes only. Please consult a legal or tax professional regarding your situation.

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Any views expressed above are the author's own and do not necessarily reflect the views of WebMD or Medscape.

Cite this: Joel S. Greenwald. 529 Savings Accounts: How to Save Money for College the Smart Way - Medscape - Aug 18, 2021.