Jovan Johnson, MBA, CFP®, CPA/PFS
Let’s face it, college is very expensive, and the cost continues to rise each year. This can make any parent nervous about whether they will be able to fund their child’s college education.
How can you get a head start? The key is to start saving for college while your kids are still young.
So, how should you start saving for college?
There are a number of different ways to save for college. Two great options are 529 plans and taxable investment accounts. In this article, we will break down each one, so that you know whether to choose a 529 plan or taxable investment account for your college savings.
Here is what we will cover:
- The pros and cons of 529 plans.
- The pros and cons of using a taxable investment account for college savings.
- How to decide which one is right for you.
1.) Pros and cons of a 529 plan
The most common way to save for college is by using a 529 plan. This account is used specifically for qualified education expenses. When used for these expenses, the plan offers great tax benefits and growth opportunities. You would be surprised by the long list of expenses that are “qualified”; however, the most relevant ones are tuition and fees (including $10,000 per year for K-12 tuition), room and board, college supplies (books, computers, etc.), and up to $10,000 in student loan repayment per beneficiary and per sibling.
The greatest benefit of using 529 plans for college is that the investments grow on a tax-deferred basis and the distributions are tax-free when used to pay for “qualified education expenses”. This is extremely powerful if you start saving for your child’s education early.
Another great benefit of the 529 plan is that many states offer a state income tax deduction or credit for contributions to the plan. So, not only can your investments grow to a large lump-sum of money, but also you may qualify for a state tax deduction when you contribute to the plan.
One benefit of 529 plans that is often overlooked is the favorable financial aid treatment it gets. If a dependent student or their parents own a 529 plan, distributions are not counted as income on the Free Application for Federal Student Aid (FASFA). Also, these plans are only reported as parental assets, which means that it will have a minimal effect on financial aid eligibility.
However, what if your child comes to you one day and says, “I do not want to attend college anymore”. Or what if they receive a full scholarship? There are downsides to having leftover funds in a 529 plan. If you were to withdraw the funds for non-educational expenses, you would pay both income taxes and a 10% penalty on the investment growth. This defeats the purpose of the 529 plan.
2.) Pros and cons of a taxable investment account
A taxable investment account is very simple and easy to open. It is an account held in your name. There are no contribution limits, penalties, limits on how many accounts you can open, or restrictions on what you can use the funds for. Also, there is a broad range of investments that you can invest in based on your risk tolerance and time horizon.
The greatest benefit of a taxable investment account is the flexibility. If your child was to decide not to attend college or received a full scholarship, the funds could be used for other financial goals. Maybe they want to use the funds instead for a down payment on their first home. This removes some of the pressure from specifically using the funds for educational costs.
However, there are no state income tax deductions or credits for contributions to this type of account. Also, once the money is taken out of the account there will be capital gains tax on the investment earnings.
3.) What should you do?
We all have passions and desires to fund our child’s college education. However, change is inevitable. Life will be forever changing, and we must constantly pivot.
Don’t put all of your eggs in one basket when saving for college. If you put all of your savings into a 529 plan, you may end up paying high taxes and penalties if you don’t use the funds on “qualified expenses”. On the opposite end, if you put all of your savings into a taxable investment account you will miss out on all of the tax benefits a 529 plan can provide, such as: potential state tax deduction/credit for contributions, and tax-free withdrawals for “qualified expenses”.
Utilizing both types of accounts allow you to still benefit from the tax-free growth/withdrawals, but you also are giving yourself flexibility if your kids don’t use all of the funds for college.
Building flexibility into your financial plan allows you to pivot when your life changes and still reach your financial goals.
Key takeaways
- Diversify your savings for college costs. Consider both a 529 plan and/or a taxable investment account to create flexibility in how the funds can be used. Don’t assume that your child will automatically attend college or won’t receive a full scholarship. Also, don’t let taxes alone drive your decision. Flexibility is just as important, if not greater.
- Don’t save excessive money in a 529 plan, as there could be potential for both penalties and high taxes.
- Just because you live in one state, does not mean you cannot take advantage of a different state’s 529 plan. Choose the plan that provides you with the greatest benefits.
- Don’t sacrifice planning for your retirement or other significant financial goals, while trying to fully fund your child’s college education.
Disclosures
None of the information provided is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Piece of Wealth Planning LLC does not promise or guarantee any income or particular result from your use of the information contained herein.
