In my previous articles on 529 plans, I provided a quick introduction to how 529 college savings plans work and how to set one up, plus the different investment options you can choose.
Now it’s time to take a look at some smart ways to use a 529 plan, including how to use one to protect and maximize your college savings and retirement, and how to compare a 529 plan with other investments to determine the best ways to help you save for college.
These are strategies that I’ve taught and helped my clients use for over 20 years in my career as a Certified Financial Planner® and college funding specialist.
Let’s jump in and get started by addressing a common mistake that many families make when it comes to 529 plans.
Never Assume It’s Too Late to Start a 529 Plan.
Many families never get to enjoy the benefits of a 529 plan because they think it’s too late for them to start one.
This is a huge mistake, so let’s start by making one thing clear:
It’s never too late to use a 529 plan.
A lot of parents and family members assume that, if they didn’t start a 529 plan when their kids were young, it’s too late to start one now. It’s especially common among parents of teenagers in high school.
Parents often think there’s no point in starting a 529 plan at such a late stage because they think there isn’t enough time for their savings and investments to grow. Instead, they decide to save their money in a savings account or checking account.
But this is a bad decision you can easily avoid by using a 529 plan to maximize your college savings, grow your money, and get tax benefits too, even if you have a student who’s going to college soon.
As a financial planner, I’ve worked with hundreds of clients over the years to help them plan and save for college using 529 plans, and many of them were parents who got started fairly late but were still able to get great advantages from a 529 plan.
Let’s take a look at why 529 plans often make sense at any stage.
Use 529 Plans at Any Stage of College Financial Planning.
It’s extremely rare that a 529 won’t provide significant benefits, even if you have a student who is a junior or senior in high school.
Depending on the state you live in, there are often significant tax breaks you can receive by making contributions to a 529 plan, and those add up to more money for college, even if your student is graduating from high school relatively soon.
Different states have different rules, but here’s an example that I discussed with John Munley, a fellow financial advisor who joined me to discuss 529 plans on my Taming the High Cost of College podcast.
John lives in New Jersey, and if you’re a married couple that makes under $200,000 per year in adjusted gross income, you can contribute up to $20,000 per year to a New Jersey 529 plan and get a major tax deduction.
The tax rate in New Jersey is 6.7%, and if you contribute the maximum to your 529 plan, you’ll save $1,300 in your state taxes.
In my home state of Wisconsin, there are similar tax benefits. These benefits are currently capped at $3,580 per year as of 2022, but that limit is per beneficiary. Thus, if you have four kids, you could potentially get that $3,580 tax break four times, for a total of $14,320. Sometimes I with clients to set up 529 plans for mom and dad as well, which allows them to get the tax deduction six times.
Now, to get the maximum in tax deductions, you typically have to invest pretty aggressively and put quite a bit of money into your 529 plan during the year. But for families with kids going off to college soon, they usually have to be pretty aggressive anyway, especially if they haven’t been saving and investing much for college until now.
Even if you aren’t investing aggressively, you can still get a nice tax break that adds up to hundreds or even thousands of dollars in many states.
Never assume that it’s too late to start a 529 plan. The tax breaks alone can help you save thousands of dollars for college, even if your student is in high school or already in college. And this is just one of several great 529 plan strategies you can use. Let’s take a look at another one next.
Use a 529 Plan to Protect Your College Savings.
A lot of parents and other family members save college money for their kids or grandkids by using a traditional savings account or checking account. But this can be a mistake, and here’s why.
One major risk of using a traditional savings or checking account to save for college is that you can end up spending some of that money for other purposes.
For example, if you end up needing money for home repairs, renovations, a vacation, a new vehicle purchase, or other major expenses, you might end up withdrawing some of your savings or checking account funds to pay for them.
This means you could be tapping into your kids’ college money without realizing it. Unless you’ve set up a separate account for college and you never touch those funds, you can easily make this mistake. However, even if you use a separate savings or checking account, you won’t be getting tax breaks for your contributions, and your money probably won’t grow like it would in a 529 plan. This is why a 529 plan is a smart way to protect your college savings.
A 529 plan is completely separate from your other bank or investment accounts, and it’s clearly earmarked for college.
When you put your money into something that’s labeled “college,” it tends to be a lot more hands-off. You’re much less likely to tap into those funds unless it’s an absolute emergency.
There isn’t that same temptation to “borrow” from the account and pay it back later, which often never happens once the funds are withdrawn. Also, the tax penalties you’ll pay for using 529 plan funds for non-educational expenses is another powerful deterrent.
Be smart and consider investing in a 529 plan because it will likely help you ensure that your college money is preserved and used for that purpose.
Use a 529 Plan to Protect Your Retirement.
Some parents, grandparents or other family members save money for college by using their retirement account. In other cases, they end up raiding their retirement account because they haven’t saved or invested enough elsewhere to cover college costs.
It’s often better to use a 529 plan instead of your retirement plan to save for college. This is because it gives you a way to save and grow money for college using a separate account that doesn’t take money away from your retirement and provides great tax benefits on top of that.
Now, some families still choose to use a retirement account to save for college because they think it’s just easier. They think 529 plans add a layer of complexity because there are rules about qualifying educational expenses and how you can use your 529 withdrawals.
Since you may have to pay tax penalties if you don’t follow the 529 plan rules, some people get scared by this. But the rules come down to something really simple: if you use your funds for qualifying educational expenses such as tuition and room and board, then you have nothing to worry about. You still get to grow and withdraw your college savings tax-free.
It’s only when you withdraw money and use it for something other than college, or for other non-qualifying expenses, that you’ll have to pay taxes and possible penalties on your withdrawals.
If you follow the rules, you get to grow your savings tax-free and can also potentially qualify for additional tax deductions and benefits, depending on your state.
Similarly, while some families don’t want to go through the extra paperwork and effort to set up a 529 plan and figure out their investments, it’s often better to do so.
This is because a 529 plan offers tax benefits that could help you save hundreds or thousands of more dollars for college. If you just invest more money into your retirement plan and use future withdrawals for college, you’ll be giving up those benefits. So make sure you understand your options and choose wisely!
Consider 529 Plans vs. Other Investment Options.
529 plans are a great way to save and grow money for college, but they’re not the only game in town. There are other places where you can put your money as well.
There are taxable accounts such as bank accounts, mutual funds, certificates of deposit (CDs) or similar options where you can get essentially the same investment options as a 529 plan. You may also be able to get a similar rate of return, since these accounts can often yield 1% or 2% in annual return.
The drawback with most other investment options is that they’re taxable, so you’ll have to pay taxes on your growth when you make your withdrawals later.
However, there are some types of accounts where you can invest and grow your money and get tax benefits too. One example is the Coverdale savings account.
Coverdale Savings Accounts
A Coverdale account allows you to make a maximum annual contribution of $2,000 per beneficiary, and you can typically get growth and tax benefits similar to a 529 plan. The big drawback with Coverdale Savings Accounts is that the contribution limits are low.
Even if you start when your child is born, and you contribute the maximum of $2,000 per year, that’s only $36,000 in total contributions over 18 years. That’s not much, and it won’t even cover one year of college at expensive schools.
If you start contributing much later in a child’s life, then your total contributions will be even lower, and you’ll have even less potentially saved and grown to help you pay for college. In contrast, 529 plans have much higher contribution limits, so you can save and invest a lot more money for college.
UTMA or UGMA Accounts
Another college savings and investment option is a UTMA or UGMA type of account. These are account types that were established under the Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA).
These are custodial accounts set up in a child’s name, and family members can contribute to them as a way to give kids money for college. But there is a huge drawback to these accounts.
A UTMA or UGMA account counts as a student asset for financial aid purposes. Since the money is in the student’s name, financial aid offices include it as part of their expected family contribution or student aid index formula, which means the funds in the account are assumed to be part of what can be paid toward college costs.
Student assets count 20% toward the expected family contribution or student aid index formulas, whereas parent assets only count for about 5%. A UTMA or UGMA account will be counted at that 20% student value, whereas a 529 plan in a parent’s name will only be counted at 5%.
Also, depending on the state where you live, once a child turns 18 or 21, a UTMA or UGMA account gets turned over to them legally, so it’s their money. They can choose to do whatever they want with it, and that might mean not spending it on college.
In contrast, 529 plans are owned and controlled by the parent or other family member, and the child is only the beneficiary. It’s a good way to save and invest money strictly for college, and you’ll have to pay taxes and potential penalties if you withdraw the money and spend it on something else or on non-qualifying educational expenses.
However, if you don’t end up needing the use all of the money for college, you can still withdraw it for other purposes, and you’ll only have to pay taxes or penalties on the portion you use for non-qualifying expenses.
Roth IRAs
Roth IRAs are typically used for retirement, but sometimes they can make sense as a way to invest money that you may later use for college.
A Roth IRA is individual retirement account that allows you to invest some of your after-tax income each year, up to a specified amount. Any earnings and withdrawals from your account are tax-free if they’re made after you reach the age 59 ½, but you can withdraw money from your Roth IRA at any time and for any reason.
This makes Roth IRAs an interesting option for college savings, especially if you’ve already saved and invested a lot of money in a 529 plan and you’re not sure whether additional contributions and earnings will actually be spent on college.
For example, let’s say that you have two kids who are planning to go to a local public university, where they each might need to pay $25,000 per year in qualified educational expenses. Over four years, that adds up to $100,000 per student, for a total of $200,000 in qualified expenses.
Now let’s say you already have $175,000 saved and invested in your 529 plans. To get to the $200,000 total they’ll need, you might need to contribute and invest an additional $25,000. But maybe you’re not sure if your kids might earn some scholarships that will lower their cost, or maybe there’s a possibility that one of your kids is going to go to a less expensive college elsewhere in your state.
Instead of putting additional contributions into a 529 plan, where you can only spend your withdrawals and earnings on qualified educational expenses in order to still get the tax benefits and avoid potential potentials, you could put your additional money in a Roth IRA, which gives you freedom to withdraw and use the money however you want.
If you end up withdrawing some of your Roth IRA money before you’re age 59 ½, you normally pay a 10% penalty. But if you withdraw it and use it for qualified educational expenses, that penalty gets waived. You still have to pay income tax on your earnings, but you won’t be penalized for the early withdrawal, and you can use the money on college if you need it.
However, if you don’t end up needing to withdraw the money and use it on college, you can keep it in your Roth IRA and continue to grow it toward your retirement.
I’ve had plenty of clients where we’ve used Roth IRAs as part of their college financial planning. Depending on their situation, we might split some of their remaining college contributions between their 529 plan and a Roth IRA. For example, if we still need to save $1,000 per month, we might put $600 per month into 529s and $400 per month into a Roth IRA.
It all depends on your situation, and sometimes it makes perfects sense. For example, if you know you’re going to have a really sizable retirement, including a pension or major 401K earnings, plus Social Security and a Roth IRA, this type of strategy can make sense.
If you’re in that situation and it’s looking like you might have a shortfall when it’s time to pay for college, you can potentially withdraw some of your Roth IRA funds rather than take out student loans.
401K Plans
In some situations, you might consider putting some of your college money into 401K plans, in order to lower your adjusted gross income and qualify for tax credits based on your income and college expenses. Depending on your state, you could potentially save as much as $1,000 or $2,000 on your taxes by strategically investing some of your college money into your 401K rather than your 529 plan.
However, there are many factors that go into this, so you need to proceed with caution. It’s very important to understand your options, your state’s tax rules and potential deductions, your 401K benefits and any company matching, how much you’re spending and investing in different ways, how much your investments might potentially earn, how old your kids are, when they’ll go off to college, how much college is projected to cost, and so on.
In some states and situations, it might not make any sense to put some of your college savings into a 401K plan. In others, it could be something to consider. Make sure to consult with a financial advisor and tax professional before you make any major decisions such as this.
An Important Reminder About 529 Plans
Before you invest in any state’s 529 plan, you should carefully consider your investment objectives and any risks, charges and expenses. This information is contained in fund prospectuses, summary prospectuses, and 529 Product Program Descriptions and other documents, which are available from a financial professional or directly from a 529 plan’s website.
Read this information carefully before investing. Some 529 plans are better than others because they offer more investment options or lower fees. And it’s also important to consider how 529 plans work in your state, whether state tax deductions are available for contributing to a 529 plan, and whether it’s worthwhile to look outside your state to see if there are any plans that offer more investment options and/or lower fees.
It’s also a good idea to consult a tax professional, to make sure you understand the state and federal rules around how you make your withdrawals and how you can use your funds on qualified expenses.
How to Find the Right 529 Plan Strategies for Your Family
To learn more 529 plans, how to start up an account, and the best college savings strategies for your family, contact me for expert guidance.
As a Certified Financial Planner for over 20 years, I’ve been helping families plan, save and invest money for college with 529 plans and other great options. I can help you identify the right choices for your family and determine which options will maximize your savings and growth so you can help make your children’s or grandchildren’s college dreams come true
To get started, contact me now.
Disclosures
Brad Baldridge is a Registered Representative, Securities offered through Cambridge Investment Research, Inc. a Broker/Dealer, Member FINRA / SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Taming the High Cost of College, Baldridge College Solutions and Cambridge are not affiliated. Cambridge does not provide tax or legal advice.
Check the background of firms and investment professionals on FINRA’s BrokerCheck.
This communication is strictly intended for individuals residing in the states of California, Colorado, Florida, Georgia, Iowa, Illinois, Indiana, Maine, Maryland, Minnesota, Missouri, Montana, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Texas, Utah, Virginia, and Wisconsin. No offers may be made or accepted from any resident outside the specific states referenced.
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