529 Education Savings Plans: Should I Consider One?

Goals and priorities change over time. When you’re younger, you might be more concerned about having fun rather than worrying about retirement, or anything else for that matter. Then, in the “accumulation phase,” the focus typically turns to wealth creation and growth. Competing demands for time and resources continue to increase, as a home purchase, saving for retirement, increased expenses that come with starting a family and saving for college are complicated by simultaneously caring for children and perhaps aging parents too. Priorities can change again later in life, which might include retirement, providing for the next generation or two, and more fully appreciating the phrase my mother used often – “youth is wasted on the young.” It might also include going back to school.

Regardless of which phase you are in, once you have addressed your basic financial needs, saving for education and retirement become essential, competing, and expensive priorities.

Key Points:

• College is expensive and costs are rising.
• Competing priorities make it difficult to save for college.
• Government provides compelling incentives to encourage saving for college and other education and training related expenses.
• Grandparents and other individuals can contribute to education savings plans to meet a variety of goals, including building an educational legacy and taking advantage of tax and estate planning benefits.
• Though not intended for this purpose, 529 plans can become part of one’s estate plan.

In recent years, public college tuition has grown at an average rate of 5% per year[i], and the cost of some private colleges is now over $75,000 per year[ii].  If you had a child this year, by 2042, college and related costs could top $200,000 per year. Of course, state schools are much more affordable. Whether in state or out of state, public or private, two years or four years (or more), the cost of college is likely to keep going up.

Beginning in 1996, the government began promoting saving for college via a qualified tuition program, also known as a Section 529 plan.

What’s a 529 plan?

A 529 plan is a higher education savings/investment account with powerful tax advantages. Starting early enhances the potential benefits because of the power of compounding. Most 529 plans operate as an account people can contribute to that can be used to pay for qualified education and education-related expenses, and is not limited to college or college-aged students.

According to the IRS, a 529 plan is “a program established and maintained by a state, or an agency or instrumentality of a state, that allows a contributor either to prepay a beneficiary’s qualified higher education expenses at an eligible educational institution or to contribute to an account for paying those expenses.” [iii] In some cases, it can also be set up by educational institutions but only for tuition prepayment.

How does it work?

529 plans are typically state run and exist in 49 states and the District of Columbia (only Wyoming does not have a 529 plan). The investment options and tax benefits vary by state. Every 529 plan has an “owner” who sets up and funds the account, and a “beneficiary” designated to use the funds for educational expenses. The owner controls the account and can change the beneficiary. According to savingforcollege.com, “sometimes it makes sense for the 529 plan account owner and the beneficiary to be the same person, such as when an adult is saving for their own graduate school or when an expecting parent wants to start saving for college before their child is born[iv].”

There are three critical elements of a 529 plan: Funding, Investing/Growth and Withdrawal.

1) Funding

• Contributions to a 529 plan can be made up to the annual gift tax exclusion amount, $18,000 per person (or $36,000 per couple) in 2024, without necessitating a gift tax return. This means a person can give up to $18,000 to any other person (and to as many people as they want) without having to worry about gift tax. Gifts above the annual exclusion amount can be made and are not necessarily subject to gift tax but must be reported on federal tax form 709. Some states limit total contributions to a 529 plan, including New York, which caps contributions at $525,000.

• Deductibility of contributions from state income taxes varies by state, and not all states offer this deduction. To get this benefit in a state which allows an income tax deduction, you generally must use that state’s 529 plan. In New York, for example, a married couple can deduct up to $10,000 of contributions annually (if filing single, the maximum state income tax deduction is $5,000). California does not offer deductions for contributions, which means Californians need not limit themselves to California sponsored 529 plans. Instead, they can pick from plans across the country. Colorado residents get a deduction for the full amount of their contribution.

• The “five-year election” allows married couples to contribute up to $180,000 ($90,000 for individuals) to a 529 plan in a single year if they elect to treat the contribution as if it were prorated over five years equally. They would file IRS form 709 in each subsequent year and potentially be eligible for a state tax deduction. The advantage of this election, which is subject to state contribution limits and potential gift tax, is that it gives more time for the money to grow and compound.

• Excluding the five-year election, contributions can be made to a 529 plan at any time, including while the beneficiary is in college.

2) Investing/Growth

• A 529 plan grows tax-free. No taxes are owed on any income or capital gains, provided withdrawals are for qualified educational expenses.

3) Withdrawal

• Withdrawals for qualified education expenses, which are not limited to college tuition, are not taxed. If withdrawals are made for non-qualified expenses, they are subject to (i) tax on the investment gains and (ii) a 10% penalty. See sections 1(B)(3)-(5) of the IRS Technical Guide below for more details[v]:
  • 1(B)(3): Qualified Higher Education Expenses:  In general, this term includes tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution. Additionally, this term includes certain expenses for a computer, software, or internet access and related services to be used by the designated beneficiary during the years of enrollment. The term also includes certain room and board expenses in the case of a designated beneficiary attending at least half-time. And in the case of a special needs beneficiary, this term includes certain expenses for special needs services.
  • 1(B)(4): Qualified Elementary and Secondary Education Expenses:  Expenses for no more than $10,000 of tuition, incurred by a designated beneficiary, in connection with enrollment or attendance at an eligible elementary or secondary school. 
• 1(B)(5): Eligible Educational Institution: An eligible educational institution is generally any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. See Section 529(e)(5). 

How are the funds in the plans invested?

• Each state’s plan has a variety of investment options, with many offering time (target date) and risk based options (ex. aggressive, moderate and conservative).
• Investment options vary from state to state but are designed for simplicity for people without any investment background.

529 plans are funded with the presumption that the beneficiary will go to college, but what if s/he doesn’t? Here are several options:

• Give it time. Sometimes kids just need a break or want to take a gap year. There is currently no expiration date by which the 529 funds must be used.
• Use the money for other qualified education expenses, such as trade school, vocational school, or a career training program.
• Change the beneficiary to another immediate family member, such as a sibling, grandchild, or even yourself. Be sure to coordinate with your tax advisor before changing beneficiaries.
• Convert up to $35,000 of the balance to a Roth IRA (as long as the plan has been open at least 15 years). This option, available since January, 2024, could be done over 6-7 years under current law, and should not be a goal of any 529 plan.

Why would you save for college using a 529 plan rather than using a brokerage account?

The benefits of an income tax deduction on contributions and tax-free growth and income provided the funds are used for qualified educational expenses are compelling. Consider this hypothetical example. Assume a married couple in the highest tax bracket living in New York state is looking to save money for their newborn child’s education. The couple plans to make $25,000 contributions in each of the first 17 years, followed by withdrawals over the next 4 years.

Over the 17 years, they will have contributed $425,000.  Assuming a conservative 5% per annum growth rate, the account would grow to approximately $678,000 by the beginning of year 18. $10,000 of the contributions would be deductible each year from their New York State income taxes, which, assuming the top state tax bracket of 10.9%, would save them about $18,000 over 17 years. Gains and income are not taxed, which saves them an additional $105,000, assuming the top Federal and state tax brackets.

In summary, $425,000 in contributions grew to $678,000 tax free, and the tax benefits totaled $123,000.[vi]  

	Investment Account	529 Plan
Total Contributions (17 years)	425,000	425,000
Growth @ 5%	253,310	253,310
Total Value of Account	678,310	678,310
Total value of tax deduction on contribution	0	18,530
Capital Gains Tax owed (years 18-21)	105,394	0
Extra Capital for qualified expenses	N/A	123,924

Are there downsides to using a 529 plan?

There are definitely things to keep in mind when considering a 529 plan, including:

• Plans vary from state to state. It’s important to understand your state’s plan, deductibility, and investment options. Not all 529 plans are created equal.
• When schools consider a family’s ability to pay, 529 plans are considered assets, which can affect the “family’s expected contribution amount” depending on who owns it. Financial aid could be affected. See question below on grandparents for more information.
• Monies invested will be subject to market risk, as with any investment.

What happens if I move to a different state?

You can roll a 529 plan from one state to another once every 12 months. Check with your state’s plan for details and requirements.

If I am the owner of a 529 plan, will it be included in my estate?

• Gifts to a 529 plan are generally treated as completed gifts, so, despite your control over the account, it won’t be included in your taxable estate when you die — unless you’re also the beneficiary.

Are there any special considerations for a grandparent owner of a 529 plan?

• You too may be able to enjoy income tax benefits, depending on your state.
• Beginning in 2024, grandparent accounts will no longer be counted against the beneficiary’s calculations for federal financial aid, though they can still count toward their CSS profile for institutional financial aid, including grants, loans, and need-based scholarships.
• Gifting to a 529 plan can be a great way to utilize your annual exclusion amount and reduce the size of your taxable estate while supporting your educational values.

Who needs this information?

• Parents, grandparents and other family members for all the reasons mentioned above.
• Employers may be able to set up automatic paycheck withdrawals for 529 contributions at no cost to the company (and potentially offer matching contributions).
• Retirees and others going back to school. Many retirees want to retire to something (not just from something). This could include taking classes at a local college or university. For instance, a friend in his early sixties recently confided in me that he was thinking about retiring in the next year or two. You will never guess what he wanted to retire to… law school! While he did not want to practice law, he was eager to gain the knowledge that a law school education commands. He would benefit from opening a 529 plan for himself!

529 plans can be terrific vehicles for saving for education. The multiple tax advantages are substantial, the power of compounding is enhanced by starting early, and the discipline of “paying yourself first” by saving for your important goals is essential to reaching them in the most effective way possible.

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[i] https://www.bestcolleges.com/research/college-tuition-inflation-statistics/

[ii] https://www.nytimes.com/2024/04/05/your-money/paying-for-college/100k-college-cost-vanderbilt.html?searchResultPosition=19

[iii] https://www.irs.gov/taxtopics/tc313

[iv] https://www.savingforcollege.com/article/how-to-change-the-beneficiary-on-your-529-plan

[v] https://www.irs.gov/pub/irs-pdf/p5834.pdf

[vi] Hypothetical performance results have many inherent limitations, some of which are described herein. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently significant differences between hypothetical performance results and the actual results subsequently achieved by any particular investment plan. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical planning does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of PSG as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however PSG cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source.  PSG does not provide tax, legal or accounting advice, and nothing contained in these materials should be taken as such. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.