When you first start to delve into the fine print of tax-advantaged 529 plans—typically shortly after your first baby’s birth—it’s daunting. It feels as though there are at least 529 different options, rules, and regulations for these funds. Actually, the 529 nickname comes from Section 529 of the Internal Revenue Code, which allows contributions to grow tax-free if used for qualified educational expenses.
Should You Choose a 529 Plan?
A 529 is one of a variety of ways to accumulate tax-advantaged savings for education expenses. Other options to investigate for tax-advantaged education savings, according to the U.S. Securities and Exchange Commission are Coverdell education savings accounts, Uniform Gifts to Minors accounts, Uniform Transfers to Minors Act accounts, tax-exempt municipal securities, and savings bonds.
Saving via a 529 plan is especially advantageous if you live in one of the 34 states (and the District of Columbia) that give you a state tax deduction for your contributions in addition to the federal benefits. Some of these deductions are lush: On the high end, they range from $10,000 per contributor for Oklahoma and Mississippi up to Pennsylvania’s double whammy: $15,000 per contributor per beneficiary.
The more closely you focus on finding the one best way to accumulate the money your baby will need for future education expenses, the more complex the decision becomes. It’s tempting to just shuffle the brochures into your bottom desk drawer and bookmark the websites in your “read later” folder to worry about later.
You are now facing the first and biggest risk of all education savings plans.
Risk # 1: Doing Nothing While Time is Most on Your Side
Weigh the following facts. In this age of runaway tuition, college costs clock in with far higher rates of inflation than the overall economy. FinAid.com’s College Cost Projector puts the tuition-inflation rate at 7.0%. By contrast, the US Inflation Calculator, using the current Consumer Price Index, puts the overall economy’s inflation at 2.3% for the 12 months ending in December 2019.
Meantime, the return on a regular savings account lags notably behind the tuition inflation rate. As of Jan. 2020, the interest rates for the best high-yield savings accounts ranged from about 1.90% to 2.25% APY. You’re going to need those tax advantages to boost the return on what you put away. Because the power of compound interest increases with time, the sooner you start, the better.
Strategy: Don’t let “paralysis of analysis” rob you of the benefits of an early start. Through your employer, you usually can open an automatic deposit payroll plan with as little as $25.
This article will focus on how to manage your 529 plan funds. First, a quick 529 tutorial. There are two kinds of 529s: savings plans and prepaid tuition plans.
Although the bigger category of 529s is referred to as the “savings plan,” in reality it’s an investment plan supervised by an official of the state whose plan you contribute to, generally the state treasurer or comptroller. The state usually subcontracts plan operation to a financial service such as Upromise, JP Morgan Asset Management, or Vanguard, among many. The money you contribute is invested through one or more state funds that are much like a mutual fund, and each state has its own rules.
529 savings plans were originally designed to pay only for post-secondary education costs. However, over the years, laws have increased the rules for qualified expenses. In 2017, the Tax Cuts and Jobs Act (TCJA) expanded the plans to cover certain costs associated with K to12 education. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 expanded 529 savings plans further, allowing participants to use the funds to pay for certain expenses associated with qualified apprenticeship programs and to pay for up to $10,000 of student loan debt.
If you’ve been scared by the stock market’s tumbles, you may find the other, smaller category of 529s more attractive. A prepaid tuition 529 plan means that rather than having your savings subject to the uncertainties of the stock market, you use today’s dollars to buy tuition credits—say, a certain number of course hours—to be used for your children’s college educations. They are like vouchers. (Room and board fees are not covered in 529 prepaid-tuition plans, though, so part of your cash still should go into a 529 savings plan for that purpose.)
Each of these plans subjects you to some built-in risk. Managing your 529 plan funds requires choosing whether to save in one or both plans and thinking your way through the challenges of handling them.
Risk # 2: The Market Falls When You Need the Cash
When you choose the savings-plan route, you are betting that your fund's investment portfolio will do well enough to raise the money you need. The Big Bad Wolf of savings-plan management is overall market volatility, more than the poor performance of a particular fund. The other challenge is how much time you are willing to spend managing that money.
Strategy: One place to get some help—age-based funds, a category usually offered along with more growth-oriented options. Also called age- or time-targeted, these managed funds adjust their investment strategy based on when you plan to withdraw money to pay for college. The longer your lead time, the more aggressive or high-yield the fund investments can be; the sooner you need it, the more conservative the investments, ensuring some money even if the market falls. This targeted strategy does not remove all risk but it minimizes risk intelligently and automatically.
Big caution: Watch for fees. Age-based funds are managed funds, and many have very high fees. Here's where to find reports on which 529 funds have the lowest fees on Savingforcollege.com. Search further for age-based funds and you'll find they aren't the least expensive type. Choosing them involves a tradeoff.
Risk # 3: With Prepaid Tuition, One Size Does Not Fit All
Let’s say you buy into the concept of “tomorrow’s tuition at today’s prices.” You see it as an advantage that you don’t have to manage the growth of the money, the state does it—just like a pension plan. But not only is the number of states offering prepaid tuition plans shrinking, but some plans are also dangerously under-funded—again, just like pension plans.
Similarly to paying points upfront on a mortgage, usually you pay a premium over today’s actual prices to purchase prepaid tuition credits, but it can still seem like a pretty good buy. The promotional language is usually very persuasive, yet as Forbes reports, most states do not actually guarantee that your prepayment will cover the actual college tuition for your child when the day comes. Especially in states with austerity-minded legislatures that are cutting education costs to the bone, you may end up with sizable extra assessments and new “fees” to cover funding shortfalls.
And then there’s the delicate matter of school choice and student performance: How likely is it that all your kids will want to go to the college you pick for them? How sure can you be that they will all get into—or through—that college?
If you don’t know the song “Plant a Radish” from The Fantasticks, this would be a good time to track it down on YouTube. It’s from the longest-running musical in the world—the first off-Broadway production ran for 42 years. “Plant a carrot, get a carrot, not a Brussels sprout,” the fathers sing, “while with child-e-ren, it’s bewild-e-rin.’ You don’t know until the seed is nearly grown, just what you’ve sown.”
The downside of prepaid plans is their lack of flexibility. Usually, the student must be attending the school at least half-time for the credits to be applied, for instance. Frequently it’s far from easy to transfer prepaid tuition credits to other schools even in the same state, and rarely can you redeem them or get close to full value except at the designated institution. The plans have “a history of difficulties,” says Reuters.
Strategy: Putting part of your family’s college money into a prepaid tuition plan may indeed turn out to be the best buy, but preserving flexibility by putting the rest into a 529 savings plan savings can be an important hedge.
Also helpful is the ruling that the beneficiary (or beneficiaries) of a 529 plan can be changed once a year, as long as you keep it all in the family. The IRS calls this a rollover and is very specific about who qualifies as family:
2. Brother, sister, stepbrother or stepsister
3. Father or mother or ancestor of either
4. Stepfather or stepmother
5. Son or daughter of a brother or sister
6. Brother or sister of father or mother
7. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law
8. The spouse of any individual listed above
9. Son, daughter, stepchild, foster child, adopted child or a descendant of any of them
10. First cousin
Risk # 4: You Spend 529 Money on Non-Qualified Expenses
Your contribution is not irrevocable. As the owner of the account, if you need to repurpose the money in a 529 savings fund for something that’s not education-related, you can do so. There are some penalties: You’ll lose the tax benefit and must repay any state tax deductions based on contributions, plus a 10% federal penalty on earnings. All the same, you can reclaim the principal: It still belongs to you. Having the financial penalty in place is a good psychological barrier to keep you living within the restrictions of the 529 rulebook, but sometimes priorities must change.
Strategy: Another layer of protection for college funds is to have an adequate emergency fund readily accessible—usually calculated as enough to cover three to six months of normal expenses. Use that before breaching your 529 plan.
Risk # 5: The State 529 Fund You Pick Underperforms
Well-diversified holdings in the 529’s investment funds offer some protection against bad markets—and past performance may give you some guidance on which investments to choose—but the most control over your earnings comes from scrutinizing the fees within your 529 plan.
The larger management fees and fund-overhead charges of brand-name operators can cost you as much as a full point, or even slightly more, off your investment return rate. Many are charged upfront before your money goes to work. They may sound small—a quarter-point here, a half-point there—but over time their inroads add up to serious money.
Strategy: Comparison-shop for both direct-sold funds and private funds. Although only states offer prepaid tuition plans, private financial firms and even college consortiums offer qualified 529 savings plans. You do not have to use your home state’s 529 savings options.
An independent financial planner—one working for a fee paid by you rather than a commission paid by a for-profit entity—can evaluate the lowest-fee, direct-sold funds for you and keep on top of deadlines and deductions. You can mentally write off the fee as necessary overhead, and you'll probably see actual cash savings over the long run. For more information on high-ranking plans, see Top Companies That Manage 529 Plans.
Which brings us to the last risk category, which is …you.
Risk # 6: You're Not Good About Saving Money
In today’s defined-contribution, 401(k) world, you are a potential risk to your children’s chances of graduating without crippling education debts, to your own comfortable retirement, and possibly to your long-term self-respect and family harmony if you can’t get a grip on saving money. There's a new strategy that could make the process a little more palatable, especially if you're the type who's more likely to buy a lottery ticket than park spare dollars in a bank.
The new savings vehicle: prize-linked savings accounts. Your minimum deposit doubles as a qualified ticket in a lottery or sweepstakes that gives randomly chosen winners a cash reward, usually from a long list of small prizes and a short list (maybe even just one per month) of flashy, big-number prizes. Credit unions in a growing number of states are setting up these accounts, and federal legislation is in the works.
Your deposit stays in the savings account, but you can walk away with the extra cash from the prize. It’s quite an odd couple: The thrill of gambling subsidizes the sedate pleasure of thrift.
One prize-linked savings group, Save to Win, already has 142 participating credit unions and is honing its offerings to find the best magic formulas to attract and reward previously intractable nonsavers. PBS NewsHour calls it “a lottery where you can’t lose.”
That’s true, although if you don’t win a prize, your savings that remain in the plan are not accumulating the earnings growth of conventional 529 plans. Solution: Don't leave them there.
Strategy: After a year—or whatever time period the particular prize-linked account designates—roll over the balance into a qualified 529 plan for the beneficiary of your choice. Your college savings fund is launched. After that, you can either start making additional deposits directly into your new 529 or funnel them through the prize-linked savings account in periodic increments.
The Bottom Line
While tax-advantaged 529 savings and prepaid tuition funds have their pitfalls, the alert plan owner can offset the risks with smart strategies and informed choices. There’s a tax-wise option to suit almost everyone.