Are You Familiar With 529 Plans? Most Americans Aren't

Maurie Backman, Contributor, The Motley Fool
July 12, 2018

If there's one thing pretty much all parents can agree on, it's that college is way too expensive. And with costs going nowhere but up, it's imperative to not only be saving for it consistently, but efficiently.

Unfortunately, most people aren't familiar with perhaps the most cost-effective means of saving for college: the 529 plan. In fact, 72 percent of Americans don't know what a 529 college savings plan is or how it works. And those who skip the 529 might lose out on some key growth and tax-saving opportunities.

How 529 plans work

A 529 is a dedicated college savings plan that allows your money to grow on a tax-free basis until you withdraw it to pay for higher education. When you fund a 529, the money you contribute doesn't go in tax-free. But as that money is invested and generates returns, you're not liable for gains on your account's earnings year after year. Rather, you get to reinvest those earnings to accumulate an even higher savings balance. Then, when the time comes to withdraw from your 529 to pay for college, that money is yours free and clear of taxes as well.

Of course, there is a catch. If you don't use the money in your 529 account to pay for qualified higher education expenses, you'll be assessed a 10 percent penalty on that cash. However, that penalty will only apply to the earnings portion of your account, not the principal amount you put in.

Furthermore, most states offer a tax deduction when you contribute to a 529 provided you choose the plan offered by your home state (which you don't have to do). Some states will even give you that deduction for funding any 529. And Indiana, Utah, and Vermont will actually give you a tax credit for putting money into a 529.

One big reason to open a 529

Tax benefits aside, the great thing about 529 plans is that they offer you the chance to invest your college savings and grow your money into an even larger sum. Imagine you decide to sock away $500 a month for college over a 10-year period in the bank. In today's interest rate environment, you'll get 1 percent back on your money each year for a total balance of $63,000, but that's not taking taxes into account. Remember, unlike the growth in your 529 plan, interest income is subject to taxes, so the reality is that your $63,000 in this scenario will be lower.

However, if you save that same amount of money in a 529 and invest it, you might generate a 7 percent return over a 10-year period. And that would leave you with $83,000 free and clear of taxes, provided that total balance is used for higher education purposes. Given that in-state tuition, fees, and room and board cost an average of $20,700 for the 2017-2018 academic year, that $20,000 difference is huge.

Of course, you're not just limited to saving for college in a bank account versus a 529 plan. There are other options you might pursue that also allow for more aggressive growth on your money, such as a traditional brokerage account or even a Roth IRA. But these have their drawbacks, too. With a traditional brokerage account, your money isn't restricted — you can withdraw it for any purpose without penalty. However, you'll lose out on the tax break a 529 would otherwise give you.

With a Roth IRA, meanwhile, your money will get to grow and get taken out tax-free as well, but you'll be capped at a relatively low annual contribution limit year after year. Currently, that limit is $5,500 if you're under 50, or $6,500 if you're 50 and over. If you're looking to save more than that for college, the Roth option probably isn't your best bet (though it's a great tool if your goal is to save for retirement).

Take a closer look

Like it or not, college certainly isn't getting any cheaper. If you're hoping to save for it as much as possible, you might as well save for it efficiently, and that could mean housing your savings in a 529. These plans are widely available and there's a lot of information about them out there, so do your research and see if a 529 is the right bet for you.

 

 

This article was written by Maurie Backman from The Motley Fool and was legally licensed through the NewsCred publisher network.