6 things to consider before opening a 529 plan

October 02, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Paying for college is perhaps a more formidable challenge today than ever. Over the last five years, tuition prices at public four-year colleges have risen by 27 percent above overall inflation, according to a recent College Board survey.

Section 529 plans -- special tax-advantaged vehicles designed to aid college savings -- are one option for tackling these growing costs. Still, these plans may not be right for every situation. Here are six key considerations that can determine whether a 529 plan is right for you and your family.

1. Time till college

Earnings on 529 plans are not subject to taxes. However, unlike a traditional IRA or 401(k), contributions to these plans are not tax-deductible. This means that there is no immediate tax advantage to starting a 529 plan, but the tax advantage will increase over time as earnings accumulate. Thus, the longer time there is until you expect to draw from the plan, the more that tax advantage is worth.

2. Likelihood of pursuing postsecondary education

The earlier you start saving, the easier it will be to pay for college. However, it's difficult to predict what educational needs a small child will have 10 or 15 years down the road. You should only start a 529 plan if there is a strong likelihood of your child pursuing postsecondary education. However, a wide variety of educational options are covered by 529 plans, including vocational schools, so there is a pretty strong chance your child could benefit from some education beyond high school.

3. Estimated cost of education

To avoid being penalized, you do not want to have money left over in the 529 plan when the beneficiary's education is completed. So, the more you expect to have to pay for college or vocational school, the more comfortable you can feel with contributing to a 529 plan.

4. Family size

While 529 plans must be set up for a specific beneficiary, there is some flexibility in allowing that money to be transferred without penalty from one beneficiary's 529 plan to another. If you have multiple children, it should reduce the risk of having money left over in a plan, because if that happens, you can just roll that money over to the next child in line.

5. Plan fees

While some 529 plans are offered by states, you are not limited to choosing the plan offered by your state. So be aware that there are competitive alternatives, and fees should be one of the foremost considerations in deciding on one of these plans. If the fees exceed the likely tax benefits, it isn't worth investing in that 529 plan.

6. Investment approach

Again, the tax benefit is derived from how much the plan earns. Given the low level of savings and money market rates these days, you may not get much tax benefit if you plan to invest very conservatively, but more aggressive, long-term investment approaches could benefit significantly from the tax treatment.

One goal with a 529 plan should be to avoid putting more in than the beneficiary is likely to need. For this reason, it may be wise to make a 529 plan the foundation for college financing, but not the way you fund the entire expense. Not only will this reduce the chance that you will be left with unused money in a 529 plan, but it will also allow you to use a 529 plan as an allocation to more aggressive investments that could benefit most from the tax exemption on earnings.

Your responses to ‘6 things to consider before opening a 529 plan’

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Marc Bautis

11 October 2013 at 7:14 am

If there is money left over in a 529 plan it can turn into a great estate planning tool. Two benefits of 529 plans are that they can be transferred to family members and there is no time frame when the funds have to be used. Because this money can grow tax-free for many years it can create generational wealth. Here is an example how. You start a 529 plan when your son is born and over the years you keep contributing to the account. When your son turns 18 you have $250,000 in the account. Your son however decides to join the circus instead of going to college. You think you may have penalties to pay and a huge tax bill, because the 529 will not be used for education expenses. Contrarily, you may be able to use that 529 plan to finance all of your grand kids education. Let%u2019s say by the time your son the trapeze artist hits 30 he has two kids. By the time your two grand kids are ready for college that $250,000 will have 30 years to grow tax free. At a 7% return you are looking at a value of over $2,000,000. In 30 years time 4 years of college may cost $1,000,000 dollars, but at least you will be one of the few people that has the money saved to be able to afford it.

Ryan

4 October 2013 at 8:21 am

Parents, check out GradSave it is a way for parents to save for their child's college education using crowd-funding. You build a community of friends and family who can gift directly from the profile page and then all gifts are transferred to the child's 529 plan. Best of all their service is free!

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