In part 1 of the HSA series, HSA: Best for College Savings or Health Savings (Medical Expenses), I talked about if it’s better to use an HSA for college savings or for medical expenses. (Hopefully the title made that clear). In that post, the main college savings vehicle I talked about, aside from an HSA, was the 529 plan. As a result, one might be left wondering, “Should I invest in a 529 Savings Plan?”
Join me as I take a look at the tax advantages and strategies of the 529 college savings plan. I’ll also review potential penalties and pitfalls of using this vehicle as an investment.
Table of Contents
529 Plan Highlights
529 savings plans and plans designed to help pay for college. Similar to 401(k) plans, 529 plans are named after Section 529 of the Internal Revenue Code (IRC).
These plans have no annual contribution limits, and have really high maximum contribution limits. Think in the $400,000 range, with some as high as $520,000. This number will change every year to adjust for inflation. The annual contribution is often limited by the gift tax exclusion, which is $15,000 for 2020.
The only requirement is the money is used for qualified higher education expenses or K-12 qualified tuition expenses. There is a 10% penalty if money is taken out for unqualified expenses.
Qualified 529 plan expenses include
- Tuition and fees
- Computers technology, related equipment and internet access
- Special needs equipment
- Room and board if the student is enrolled at least half-time
- Up to $10,000 in K-12 tuition expenses (per year, per beneficiary)
- Student loan payments (Added in 2019)
- Costs of apprenticeship programs
Non-qualified 529 plan expenses include:
- College application and testing fees
- Transportation costs
- Health insurance
- Extracurricular activities
- Expenses used to generate federal education tax credits
- Any expense that is not considered a qualified education expense
The named beneficiary has no legal rights to the funds in a 529 account, so you can assure the money will be used for its intended purpose.
The beneficiary can be changed to certain other family members, like another sibling or a grandchild.
Taxes when you invest in a 529 plan
Similar to a Roth IRA, contributions are not tax deductible, but earnings in a 529 plan grow federal tax-free.
Individual states may offer tax breaks as well. There are currently 30 states that offer some sort of tax advantage, so be sure to check. I’m in Texas, where there are no income taxes, so there is no tax break.
The contribution portion will never be subject to tax or penalized since it was made with after-tax dollars.
There is a 10% penalty if money with taken out for unqualified expenses.
If earnings from the 529 plan are taken out for unqualified expenses, there is a 10% penalty on top of paying income taxes. Taxes are assessed at the beneficiary’s income tax bracket.
How much of a tax penalty is it really?
When you consider that money in a taxable account would have been taxed at your ordinary income tax rate already, 529 plans are still a better option. In the 529 plan, earning grow tax-deferred. Taxes are then assessed when the money is withdrawn (for unqualified expenses), at the beneficiary’s tax rate. Considering that the beneficiary is usually a college student, their tax rate is often lower than the parent, who at least made enough to be able to save extra money into the 529 plan. Often, the beneficiary’s rate is at least 10 percentage points lower than the parent’s rate, so the parent is no worse off than they would have been had they saved in a taxable account.
(Of course, my FIRE readers will point out that it’s possible to manage investments in individual stocks to minimize capital gains, and that the Tax Cuts and Jobs Act of 2017 cut the minimum long-term capital gains rate to zero for low and moderate income families earning up to $77,220. For families earning $77,221 to $479,000, the long-term capital gains tax rate is 15%. Beyond that the long-term capital gains tax rate is 20%.)
Financial Aid Penalties when you invest in a 529 plan
The 529 plan is a factor the FAFSA considers. Having money invested in a 529 plan will affect the amount of financial aid a student qualifies for.
A 529 plan owed by the custodial parent(s) typically counts as an investment and it may reduce need-based aid by a maximum of 5.64% of the asset’s value.Forbes
If someone else besides the custodial parent owns the account, the rate goes up and it only gets worse. Forbes does a good job explaining the details in this article.
Note: 5.64% is the magic number used to determine how much of the parent’s assets can be used towards college. This is in addition to the amount based on AGI
As an example, let’s say you had $300,000 in the 529 plan when your kid goes to college. This would reduce the “need-based aid” by $ 16,920.
Consider how that will affect the aid received with the average cost of tuition. Forbe’s also put together on the Expected Famlity Contribution (EFC) based on Adjusted Gross Income (AGI) and number of dependent children in the household. You can add the number calculated previously to your EFC result in this table to determine your full EFC.
The average cost of public colleges in the United States is $9,970 for in-state tuition and $25,620 for out-of-state tuition, not including room and board.ValuePenguin
Will my kid even go to college?
According to the Bureau of Labor Statistics, 69.7% of high school graduates enrolled in college by the fall after they graduated.
As can be expected, this rate changes depending on the parent’s education level. This rate goes up to 82% if the parents are college educated, and down to 36% if neither parent graduated from high school.
Check out this info from National Center for Education Statistics
Factors the affect FAFSA
Parents assets are broken down into two classes: Unprotected assets and Protected assets. 5.64% of a parent’s unprotected assets are expected to be used towards funding college.
Protected assets are not counted at all.
Unprotected assets include
- Savings and checking accounts,
- Investment accounts,
- Non-retirement tax-deferred savings plans such as 529 accounts,
- Tax-exempt interest income,
- Tax credits,
- Investment property,
- The net worth of a business with over 100 full-time employees,
- Income from retirement accounts
- Everything else you can think of not listed in the next section.
Protected assets include
- Family’s primary residence
- Retirement accounts
- Traditional and Roth IRAs, 401(k) plans, and pensions
So, Should I Invest in a 529?
The short answer is probably yes, you should invest in a 529 plan, but it depends.
If you plan to use the money in less than 5 years, then don’t use a 529. That’s my general rule for investing any money. The stock market could go down, and you might actually lose money. Plus, 5-years won’t earn you that much interest either. If you plan to use the money further down the road, then you can start weighing the other options.
It’s hard to predict the future, but if you are a careful planner, and strategically place money in your primary residence and retirement accounts, have no income or very-low income, with little cash in your bank accounts, then in might be better not to invest in a 529 plan.
For those of us aiming for early retirement, that might be a viable goal.
However, if your reading this and planning that far into the future, the chances are that you will have a decent income, and hopefully a sizeable amount of money outside of your retirement accounts. That would result in a high EFC, resulting in a low amount of financial aid received.
The numbers nerd in me likes to run through different scenarios, and there is a calculator specifically built for this, the EFC calculator, by College Board. Go have fun and determine what works best for you and your family.
That said, there are higher priority investments to make before investing in a 529 Plan.
If you are employed and are able to contribute to a 401(k), Invest here and get your employer match.
Next, max out your HSA. It is the most tax advantaged account out there, so take advantage of it. You can learn all about it here:
HSA and Tax Returns: Your guide for contributions, withdrawals, and tax forms
If you are eligible, contribute to your Roth IRA. Roth IRA savings can be withdrawn early, without penalty, to help pay for education expenses. The amount saved does not affect the student’s EFC. Only the amount withdrawn and used for school expenses will have an effect.
After all of those accounts are maxed out (aside from the 401(k)), then start contributing to a 529 plan.
How we Invest in a 529
We are personally invested in a 529 account. I may be retired by the time Gone On FIRE Jr. #1 goes off to college, but I don’t think my wife plans to leave her current career by then. Also, hopefully, I will bring in some money from side hustles. Secondly, we plan to be invested in rental properties. That means having a lot of unprotected assets, resulting in a high EFC. Having a 529 plan will not change the EFC by much. I fully expect that Gone On FIRE Jr. #1 will not qualify for much financial aid. Hopefully the kids will get some scholarships, but I’m not banking on that either.