This is a segment of Bautis Financial’s college planning series, which includes webinars, podcast episodes, blog posts and downloadables to aid college-bound students and families in the admissions process. Visit our college planning hub for more valuable resources.
Since its creation in 1996, the 529 college savings plan has exploded in popularity. In fact, it is probably one of the most “asked about” ways to save in our practice. As parents who have gone through the pains of figuring out how to pay for college (or continue to pay) are having kids of their own, it is no surprise they are looking for ways to get ahead. With the tax advantages 529 plans provide college savers, it’s no wonder why parents would want to consider them as part of their savings plans. But like most things in life, there are advantages and disadvantages to funding these accounts as part of a long-term plan.
The biggest difference between the 529 college savings plan and other ways to save are the way it is taxed. A 529 plan’s tax advantages work much like a Roth IRA: Your contributions to the plan will be “after-tax,” or in other words, it will not reduce your taxable income in the year contributions are made.
The real advantages come after you make the contribution. If the funds are used for “qualified education expenses,” then you will never pay tax on that money again. More on the “qualified education expenses” later, but first let me give you an example of how these tax advantages will compare to a traditional investment account.
Let’s first take a look at the taxation of a standard individual or joint investment account. When you make contributions to these investment accounts, they are post-tax like the 529 plan. Once you make the contributions, the account will be taxed in a couple of ways.
- On dividends and interest. Depending on the type of investments you choose in your account, you may have either dividends and/or interest paid to the account. You will pay the appropriate tax rate on these payments in the tax year they are awarded.
- On the “realized” capital gains. When the value of the assets in your account grows it is called capital gains. Until you sell the assets the growth is considered “unrealized gains” and is not taxed. It is not until you sell the asset that this growth becomes “realized gains” and in turn will be taxed in the year of the sale.
Again, after you make a contribution to a 529, you will not pay any more tax. So the dividends and interest get paid tax free and the gains will come out of the account tax free. These savings can be significant over time.
Here is an example of the difference these tax advantages can make over a 10 year period:
Let’s say you open an investment account with $10,000, and invest in a portfolio that gains 8% and pays an average of 1% of dividends and interest every year. Considering the 8% gain and taxes you will have to pay, you will have about $18,000 once you make a full withdrawal from the account in 10 years. In contrast, if you were to take the same $10,000 and put it in a 529 savings plan, you would have about $21,500 to pay for college. This is over 40% more growth over the same 10 year period.
So, you might be thinking this seems to be a no-brainer. With such a savings why wouldn’t you use a 529 plan? Well, this brings us back to the “qualified education expenses” we discussed earlier. There are certain expenses that you can pay for that will be free of tax when using the funds from a 529, like: Tuition, books, computers, room and board, etc. You can even use it for secondary parochial and private schools free of tax. If you were to take a distribution for anything other than a qualified education expense, you will pay ordinary income tax AND a 10% penalty on the gains.
While a 529 may seem like a no-brainer if you think you’ll use it for education, it is hard to know that for certain when you start saving 18 years in advance. But, it is easy to transfer the beneficiary of the account to other siblings as well as to grandkids to hedge your bets, and there are even ways around avoiding penalties in the event there is a scholarship. As you can see, it is not as easy as just considering the tax savings. A good plan will of course take this into consideration but will also consider alternatives.
If you would like to know more about how you might be able to use a 529 or other accounts to plan for your education goals, or if you have any other questions concerning any financial decision you are facing, we’d be happy to help. You can set up a free consultation below.