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Are 529s still worth it?


The 529 plan has been a popular way to save at least some of the money earmarked for future college spending since they became available in the ‘90s. They offer a tax-advantaged way to save money for college: you establish a plan, name a beneficiary, make contributions on a schedule and at an amount that makes sense for your cash flow, the money is invested and grows tax-free, and then can be used (both the original investments and the growth) tax-free for qualified education expenses. Nearly all states offer one, and many states offer a tax deduction on contributions for residents as well (there’s no federal tax deduction, though). You are free to choose any state’s plan, and the money can be used for any eligible institution, including some non-US schools.

Here are answers to some common questions about the plans:

How much can I contribute? 

Technically, to keep things simple tax-wise, it’s best to stick to the annual gift tax limit: for 2021, that’s $15,000 per recipient per giver. So, for example, a married couple with two children, and a 529 plan for each of them, can contribute $30,000 this year to each plan. Or, if your state offers a tax deduction, you may want to co-ordinate your contributions with the deduction limit (for example, in New York State, the maximum a married couple can deduct is $10,000 per return).

What are qualified education expenses?

It’s a pretty broad list: tuition and fees (for both full-time and part-time students), room and board (both on-campus and off-), required textbooks and supplies, technology (devices, internet service and printers), and special needs and adaptive equipment needed to participate in courses.

What happens to the money if the beneficiary doesn’t need it?

This is a great question! There could be scholarships, grants, and substantial aid that means the beneficiary doesn’t need all the 529 funds accumulated. And what if they decide not to go to college at all? One of the great benefits of the 529 plan is its flexibility: you (the owner) can change the beneficiary: maybe another child can use the money, or maybe you yourself want to use it for your own continuing education. Or, maybe the original beneficiary is considering graduate school someday: you can just leave the account alone until someone needs it.

But what’s the worst case scenario here? You need to access the funds for a non-qualified expense. If that happens, you will pay income tax, and a 10% penalty on just the earnings portion of the distribution. In addition, if you received a state income tax deduction for your contributions, your state may claw back the tax break you got. Given the breadth of qualified education expenses, and the possibility of leaving the assets there for someone else to use someday - even your grandkids! - this step should only need to be taken in the case of a significant financial emergency. In which case, the tax impact is easily calculated so you can make an informed decision.

Won’t it have a negative impact on financial aid awards?

This is a myth that’s gotten overblown. It’s true that it’s an asset that gets counted in the Expected Family Contribution, but the impact is pretty minimal: only 5.64% of the balance in parent-owned plans is considered.

I suspect that the hesitancy around using these plans is centered around a troubling all-or-nothing habit that I’ve noticed forming in financial planning in general: that there’s only one good answer to something, and one product or idea being valuable or beneficial necessarily means the others should get tossed out the window. This is untrue of course, and will limit you from creating a flexible, resilient plan. But the 529 does provide some real benefits and it’s wise to make use of one for at least some of your college savings dollars.

To be sure, the college landscape is changing - the pandemic has accelerated trends that were already taking form, and the costs of a college education are spiraling out of reach for many, without the resulting income that might make it seem worthwhile. In addition, there’s renewed interest in addressing the real and significant student loan crisis. Still, my sense is that college, and college costs, won’t go away in the coming decades, they will simply change. There will likely always be qualified expenses that 529 assets will cover, even if there’s a migration away from the high tuition + room and board fees for 4 years model we have now, to more ad-hoc and modular costs.

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