Saving For College: Introduction to 529 Plans

Saving for a child’s college education is one of the biggest expenses in a young physician’s budget. Most physicians will not qualify for need-based financial aid, and you can hardly count on your child to earn a merit or athletic scholarship. Fortunately, the 529 account can provide a significant tax break on the high cost of college education, if you plan ahead.

What is a 529 plan?

A 529 plan is a tax-protected investment account run by individual states. You don’t have to be a resident of that state in order to open a 529 plan in that state. In many cases, individuals choose to open a 529 in a different state from where they live because of its better investment options. However, some states offer a state tax deduction for contributions, which may mean investing in your own state’s 529 is the best option.

When can I open a 529 for my child?

Generally, you can open a 529 account for a child as soon as he gets his Social Security number. In reality, you can effectively open a 529 for your unborn child whenever you want. The 529 account is an account in your name, with the beneficiary being your child. You can change the beneficiary at any time, so if you wanted to open a 529 account for your unborn child, you could open a 529 and initially list yourself as the beneficiary. When your baby is born, you then change the beneficiary to your child once he or she has a Social Security number.

How much can I contribute in a 529?

The primary limitation on 529 contributions early in a child’s life is the gift tax exclusion; for 2018, this means that you can contribute $15,000 per person per year to the 529 before contributions start counting toward the annual lifetime gift tax exclusion. An option to give more than $15,000 in one year, typically utilized by grandparents, is to frontload 529 contributions; this allows them to give 5 years worth of contributions in a single year (of course, they would not be able to give additional money to the child for the next 4 years).

Many 529s have a maximum account value (which varies by state), after which you cannot add any additional contributions. Your current contributions can continue to grow, but you wouldn’t be able to put any new money into the account after the account value exceeds this maximum.

What are the tax benefits of a 529?

There are three main tax benefits of a 529:

Possible upfront state tax deduction

Unlike a 401(k) or HSA, there is no federal income tax deduction for 529 contributions. However, many states do offer their residents a state tax deduction for 529 contributions.

Tax-deferred growth

Your investments will grow tax-deferred. If you change your investment allocation within your 529, you don’t have to pay any capital gains on any investments that are sold.

Tax-free withdrawals for college

You don’t have to pay taxes on withdrawals from the 529 if they are used for eligible college expenses. If you choose to withdraw the money for non-college expenses, then you will have to pay ordinary income taxes on the withdrawal, plus a 10% penalty.

Do I need to save 100% of my investments in a 529?

A 529 plan is merely a vehicle designed to give a tax break to Americans saving for the college educations of their children. It is not necessary that you save all of the money your child could potentially need for college in a 529 before they finish high school.

For many families, saving the full college tuition for a child before they finish high school is not feasible. Even if you are planning to fully save for your child’s education before they turn 18, because of the fluctuations in investment returns and college tuition, it would be impossible to hit the exact cost of your child’s future college to the dollar. You should merely consider a 529 as an opportunity to get a discount on the overall cost of college in the form of tax breaks from the government.

To cover the difference between the cost of tuition and your 529 balance, you can choose to pay for your child’s college education through money in your taxable account, or simply pay the tuition from your paycheck while they are in college. Your child could also work during college or take out student loans, although I believe that most physicians should be able to pay for their child’s college on a doctor salary.

What happens if my child doesn’t need the 529 money for college?

In some cases, you may not spend all of your 529 money for your child. Maybe they chose to go to the local public college, while you saved for them to go to a private college. Maybe they earned a merit or athletic scholarship. Maybe they chose not to go to college at all.

In this case, your 529 money is not lost. You can simply change the beneficiary to another relative, such as another child or a niece. Some people will choose to hold onto the 529 and change the beneficiary to their grandchildren.

What are the investment options in a 529?

The investment options are limited to those provided by the specific 529 plan, similar to 401(k) plans. You choose your initial investments from the options provided, and you can change your investment allocation whenever you want. It is not like an IRA where you can invest in individual stocks or other investments. Most 529s offer a menu of mutual funds to choose from. Many states offer low-cost index funds, which enables you to pay very little in fees on your investments. 529 plans usually also have a small administrative fee on top of the management fee for the individual mutual funds.

Which 529 plan should I choose?

There are many excellent 529 plans to choose from. You should always look at your own state’s 529 plan, because many offer a state tax deduction for 529 contributions. Then you should look at a few out-of-state 529 options. Good out-of-state options (there are others) include Utah, New York, California, and Michigan.

Conclusion

529 plans are the primary investment vehicle for paying for college. They offer generous tax benefits, reducing the effective cost of college for your children. Many states offer 529s with low-cost index funds. When choosing a 529 plan, review the plans of several states, including your home state, Utah, New York, California, and Michigan.

What do you think? What state do you have your 529 for your children? Do you have any questions about 529 plans?