Summary/TLDR
529 Saving Plans can offer parents incredible tax benefits when it comes to college savings, such as investment growth being tax-free or contributions being exempt from state income taxation. The purposes for which they may be spent, however, are relatively inflexible compared to other options. Taxable accounts, as their name implies, don’t offer any tax advantages, but don’t come with any strings attached. The cost of using a taxable account, however, also includes the opportunity cost of needing to save extra to account for the eventual taxation of the funds.
Introduction
Investment into your child’s education is one of the most important and significant investments that you will make in your life. Unfortunately, the rising cost of higher education in this country has made the goal of a debt-free college degree one that appears to be increasingly out of reach. Rest assured, however, that there are options! When it comes to saving for your child’s college education, the two best options are generally 529 accounts and taxable brokerage accounts. In this post, we’ll explore the characteristics of each option, as well as the advantages and disadvantages of each.
Great Option 1 – 529 Saving Plans
529 Saving Plans are state sponsored programs that offer tax-advantaged savings for college education. Money that is contributed to a 529 gets invested in one or more mutual funds and grows over time. When your child goes to college, the funds may be used for qualified educational expenses, discussed below, and are tax free upon distribution. This is significant because, as long as you start when your child is young, the funds you’ve saved will have grown tremendously.
For example, say you had a goal of saving $300,000 for your newborn child’s college expenses. You would need to contribute approximately $5,981 per year to have this amount saved in 18 years, as can be seen in the schedule below:
As you can see, almost two thirds of the account would be from growth ($192,343), all of which would be taxable if the funds weren’t in a 529! Depending on your taxable income, your tax bill on this amount could be $28,851-$38,468!
Today, there are over 100 529 Saving Plans in existence since multiple states have more than one program. Most 529 Saving Plans have no residential requirements for participation, meaning that you can participate even if you aren’t a state resident (although many will offer additional tax advantages to residents). Furthermore, most 529 Saving Plans may be used to pay college expenses at any public or private university nationwide, regardless of the state sponsoring the plan.
There are no maximum contribution limits for 529s, and minimum contributions are frequently as low as $25.
Qualified Educational Expenses
Remember, 529 Saving Plans only retain their tax favored status if the funds are eventually used for qualified educational expenses. Fortunately, what the IRS considers to be a “qualified educational expense” is quite broad and includes: tuition and fees, room and board, books and supplies, and even computers, software, and internet access. This doesn’t mean that every expense that you can think of is covered, but it is good to know that most of your major expenses are. A great discussion of what is and isn’t considered a qualified educational expense can be found here.
Furthermore, the spending must take place at a qualified institution including public universities and even include trade schools.
What if my child doesn’t go to college
If you take a distribution for anything besides qualified educational expenses, the growth will be 100% taxable and subject to an additional 10% tax penalty – ouch! This doesn’t leave parents without options, however. If your child doesn’t go to college, or doesn’t need all the funds that you’ve saved for them, then you may:
Change the beneficiary of the account to another family member (including yourself) and pay for their qualified educational expenses.
Beginning in 2024, up to $35,000 of remaining funds in a 529 may be transferred to a Roth IRA for your child. There are some additional requirements for this option, so don’t do it without the guidance of a professional.
What if my child gets a scholarship?
If your child earns a scholarship, you may take a distribution for an amount equal to the scholarship penalty free (not tax-free!).
Great Option 2 – Taxable Brokerage Accounts
With taxable accounts, what you lose in tax advantages you gain in flexibility. There are no strings attached to the savings – meaning you can use them for whatever purpose you’d like. If your child doesn’t go to college or doesn’t need all the funds you’ve saved up, you can use them for whatever else you’d like without any penalties. Any growth in the account, however, is always taxable.
Taxes aren’t the only cost you pay in a taxable account, however. You need also consider that to save the same amount after-taxes in a taxable account, you must save more than you would if you used a tax favored account such as a 529. For example, to get the same $300,000 of savings as we did in the example above, you would have to save $6,617 annually, or about $636 more per year than you would in a 529. This means that you don’t only lose a hefty amount to taxes, but you also must contribute almost $12,000 more to this account to get the same $300,000. This $12,000 could have been used to save towards other goals, however. And for one child, perhaps $12,000 over 18 years isn’t a big deal, but for families with 3, 4, 5, or more children, the cost can be considerable.
On the flipside, you aren’t faced with any ugly penalties for non-qualifying expenses. Furthermore, the growth in the taxable account is taxed at a more favorable rate than the growth in a 529 if it happens to be distributed in a fashion that would make it taxable.
Conclusion
529 Saving Plans and taxable brokerage accounts can provide a means of saving funds for higher education. While 529 plans offer tax advantages and are designed for education savings, taxable brokerage accounts provide greater flexibility and control over investments. Analyzing both options in conjunction with your financial plan can pave the way towards securing your child’s educational future without a hefty debt burden.
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