A 529 is a tax-advantaged savings plan designed to encourage saving for future college costs.
It offers two main benefits:
- Tax-free withdrawals for qualified education costs.
- Often state tax deductible (more on this later), though not deductible on a federal level.
For example, say you put $10,000 into a 529 plan. Depending on the state, you might receive a deduction, saving you anywhere from $200 to $1,300 in taxes. By the time your child (or even you) is ready for college, the amount may grow to $30,000. You can use that $30,000 for qualifying educational costs without paying any taxes.
A 529 plan can only have one owner (also called a donor), so it’s very important to name a successor owner to take over the account in case of death. Typically, people open a 529 plan under their own name or their spouse’s name and name their child as the beneficiary. You can always change the beneficiary later.
There are two types of 529 plans:
- Prepaid tuition plans
- College savings plans
Prepaid Tuition Plans
Prepaid tuition plans allow you to purchase the cost of future college tuition at today’s prices. The state guarantees that the value will keep up with tuition inflation. The price you pay will vary depending on the student’s age and the tuition rates. Many prepaid plans only cover tuition, not room and board.
For example, you might make a one-time payment of $65,000 for four years of university. When your child attends college, the tuition will be covered, even if the cost has risen to $100,000. Generally, you can also opt for a payment plan (e.g., $1,400/month for five years).
Prepaid plans are contractual obligations and can be very costly if you decide to cancel.
College Savings Plans
529 savings plans are state-sponsored investment accounts. Unlike prepaid plans, the investment returns depend on market performance. Think of a savings plan as a typical brokerage account where you contribute funds and invest them in an X/Y fund.
You can choose any 529 plan offered by any of the 50 states, but many states offer a state tax deduction for investing in their own state’s plan.
The investment options in the savings plan typically depend on the state/provider. The most common option is an age-based portfolio, which diversifies funds and adjusts risk based on the child’s age. These funds become more conservative as the child grows older. They are very similar to Target Retirement Funds, except they focus on the enrollment year rather than the retirement year.
These portfolios are broadly diversified and automatically adjust to more conservative positions as the child ages.
Which One Is Better?
From a numbers standpoint, it comes down to this question: “Do you believe the cost of tuition will increase faster than stock market returns?” If you think tuition will rise by 15% annually, the prepaid plan is superior. If you believe market returns will outpace tuition growth, a savings plan is better. For example, tuition at Illinois public universities grew 49% (inflation-adjusted) from 2007 to 2022, while the S&P 500 returned 138% (inflation-adjusted) during the same period. Although past performance doesn’t guarantee future results, it can be a useful indicator.
In terms of flexibility, a savings plan is much better. You aren’t committed to a specific contract. You can contribute $500 a month today and stop tomorrow if needed. This flexibility is one of the main reasons why people prefer savings plans over prepaid plans. However, prepaid plans provide certainty—you don’t have to worry about stock market fluctuations. That said, some prepaid plans don’t allow attendance at out-of-state or private universities, so be sure to check the details.
Tax Benefits
If your state doesn’t offer tax benefits or doesn’t have an income tax, you can open a plan in a state that offers the best investment options and the lowest fees. Fidelity offers an excellent 529 plan with great investment options.
Five states (Arizona, Kansas, Maine, Minnesota, Missouri, and Pennsylvania) provide tax benefits for contributions to both in-state and out-of-state 529 plans, so you can choose the lowest-cost plan, whether it’s within your state or outside.
The below is the list of states and their tax benefits/contributions amounts (if any) per FinAid :
Alabama – $5,000 single / $10,000 joint beneficiary
Arizona – $2,000 single or head of household / $4,000 joint (any state plan) beneficiary
Arkansas – $5,000 single / $10,000 joint beneficiary
California – None
Colorado – Full amount of contribution
Connecticut – $5,000 single / $10,000 joint beneficiary
Delaware – None
Georgia – $4,000 single / $8,000 joint beneficiary
Hawaii – None
Idaho – $6,000 single / $12,000 joint beneficiary
Illinois – $10,000 single / $20,000 joint beneficiary
Indiana – 20% tax credit on contributions up to $5,000 ($1,000 maximum credit)
Iowa – $3,439 single / $6,878 joint beneficiary
Kansas – $3,000 single / $6,000 joint beneficiary (any state plan), above the line exclusion from income
Kentucky – None
Louisiana – $2,400 single / $4,800 joint beneficiary, unlimited carry-forward of unused deduction
Maine – None
Maryland – $2,500 single / $5,000 joint beneficiary, 10-year carry-forward
Massachusetts – $1,000 single / $2,000 joint beneficiary
Michigan – $5,000 single / $10,000 joint beneficiary
Minnesota – $1,500 single / $3,000 joint beneficiary
Mississippi – $10,000 single / $20,000 joint beneficiary
Missouri – $8,000 single / $16,000 joint beneficiary
Montana – $3,000 single / $6,000 joint beneficiary
Nebraska – $10,000 ($5,000 for married taxpayers filing separate returns)
New Jersey – None
New Mexico – Full amount of contribution
New York – $5,000 single / $10,000 joint beneficiary
North Carolina – None
North Dakota – $5,000 single / $10,000 joint beneficiary
Ohio – $4,000 single / $4,000 joint beneficiary, unlimited carry-forward of excess contributions
Oklahoma – $10,000 single / $20,000 joint beneficiary annually, five-year carry-forward
Oregon – $150 single / $300 joint beneficiary (up to $30,000 income, reduced % for higher income)
Pennsylvania – $15,000 single / $30,000 joint beneficiary
Rhode Island – $500 single / $1,000 joint beneficiary, unlimited carry-forward of excess contributions
South Carolina – Full amount of contribution
Utah – 5% tax credit on contributions of up to $2,040 single / $4,080 joint beneficiary (max credit $102/$204)
Vermont – 10% tax credit on up to $2,500 single / $5,000 joint beneficiary (max $250 per taxpayer, per beneficiary)
Virginia – $2,000 single / $2,000 joint beneficiary, full contribution for taxpayers over 70, unlimited carry-forward
Washington, DC – $4,000 single / $8,000 joint beneficiary
West Virginia – Full amount of contribution
Wisconsin – $3,340 single / $3,340 joint beneficiary
Contribution/Overcontribution
A good rule of thumb for determining your annual contribution is to estimate the current net price for the university and contribute one-fifth of that amount each year.
Using the University of Illinois as an example, the overall average net price for a year of school is about $20,000. Our rule of thumb suggests an annual contribution of about $4,000, which is $20,000 ÷ 5.
With a 529 savings plan, you might run into the issue of over-contributing—where you save more than necessary, pay for the education, and still have a balance left in the plan.
If that happens, there are a few options:
- Conversion to a Roth IRA: If the 529 plan has been open for at least 15 years under a specific beneficiary, you can convert up to $35,00 to the Roth IRA. Annual conversion amounts are limited by Roth IRA contribution limits.
- Change the beneficiary: You can transfer the 529 plan’s beneficiary to another child, a niece, nephew, grandchild, or even yourself.
- Withdraw the funds: You can withdraw the remaining balance, but you’ll be subject to taxes and penalties on the earnings, not on your original contributions.
I hope you learned something new today. Any questions? You can always reach out.
See you next Saturday.
MC, CPA