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- A 529 savings plan is a state-sponsored, tax-advantaged account to save and invest for education.
- Each state sponsors its own 529 savings plan, and you aren’t restricted by state: You can put your money in the one that best suits your needs.
- If you save too much in a 529, you may have to pay taxes and penalties to get the funds out — but you’re allowed to transfer the funds to another person, to use for their education expenses, instead.
A 529 savings plan is a type of college savings plan that can give you a tax benefit while saving and investing for education-related expenses.
Does that make this a magic account everyone should use to save for their kids to go to college? Maybe not.
529 plans also have some big downsides you should consider before you invest thousands of dollars.
How 529 accounts work
A 529 plan is a type of tax-advantaged investment account for education. When you fund a 529, your investment can grow tax-free until you withdraw funds to pay for qualified education expenses. Those can include things like private school tuition for younger kids, but the most popular uses are college tuition, fees, room and board, books, and supplies.
529 plans are administered at a state level. You can choose your own state’s 529 plan if you like it, but you don’t necessarily have to go with your state’s plan. Each state offers different investment options, account fees, and restrictions on how you use the funds. Each state can also decide if your 529-related growth is tax deductible.
You or anyone else can contribute to a 529 in your child’s name — or your own. You control the funds, similar to any account you would hold for a minor. When it’s time to pay for school, you can sell investments and withdraw from the account to pay for those expenses or reimburse yourself for expenses you already paid out-of-pocket.
Tax benefits of a 529 account
A 529 isn’t necessarily the best tax-advantaged account out there. An HSA gives you tax-free contributions, growth, and withdrawals, while 401(k), IRA, and similar retirement accounts give you a major tax deferral for retirement.
A 529 works more like a Roth IRA. Your contributions are made with after-tax dollars, but you don’t pay any taxes on qualified withdrawals. The longer you have to invest, the more valuable that tax benefit typically becomes.
If you invest in a diverse group of low-fee index funds, you could see your account value grow dramatically. Unlike a taxable investment account, you don’t have to pay capital gains taxes on withdrawals. That can be a big savings!
If you’re looking to invest outside of a 529, consider these investment accounts from our partners:
Downsides of a 529 account
Few things in life are too good to be true, and a 529 is no different. These accounts have some major downsides as well.
- Taxes and penalties on non-qualified withdrawals. If you overfund a 529, that money may be stuck there unless you are willing to pay taxes and penalties, which can add up to a big chunk of your account value. While you can transfer funds to another family member with no penalty, that isn’t always something you want to do. I am automatically contributing to a 529 for both of my kids, but too aggressively. I can always supplement school costs from other savings, but I can’t undo extra 529 contributions.
- Not always tax deductible at the state level. While a 529 is treated equally no matter where you live when you file federal taxes, not all states give you a tax benefit for this kind of account.
- You may be restricted to in-state schools. Some states give you the ability to use your account to fund an education at any university in the US, but your state’s 529 might not. If you want to give your kids more flexibility in their choice of college, you can choose another state’s plan.
- Your investment options could be limited. I live in California, and I can invest in a 529 using low-cost Vanguard funds and pay almost no fees. Other states might not be so generous. Again, inspect your state and other state’s plans to find the one that works best for your household’s needs.
If everyone finishes school and you have money left over, you can put it in your name to finally take that pottery class at the local community college you’ve been thinking about. You can transfer to a fairly wide range of family members, so don’t rush to withdraw funds and pay penalties before you’ve checked all of your options.
Like a Flex Spend Account (FSA), 529 accounts can offer great tax benefits when you plan well. If you don’t, however, you could end up losing money or paying a heap of taxes and fees.
So if you do plan on spending for education in the future, by all means, take advantage. Just take your time and plan well so you don’t over-fund an account. When you use it right, a 529 plan can save you hundreds or thousands of dollars on taxes.
See Also:
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- These 8 simple rules are the Sparknotes version of everything you need to know about managing your money
- How to choose the right online bank to organize your money, build wealth, and make your life easier
SEE ALSO: 8 things I should have done differently while saving money to retire early at 38
Source: Business Insider – ehoffman@businessinsider.com (Eric Rosenberg)