One of the most challenging parts of college isn’t getting accepted – figuring out how to pay for it. Long before your child selects a major, their college savings plan should be in place and growing. One popular method of saving for college is a 529 account, which allows contributions to grow tax-free so long as the money is used for education purposes.
So, when do you start? What’s the right investment strategy? How should it change over time? What can you use the money for? These are just a few of the biggest questions regarding 529 accounts.
1. Why a 529 plan?
529 plans are tax-advantaged savings plans for education (more on that later). They do not require a set contribution or regular savings. They are flexible in that you can contribute as your budget allows.
When you contribute to a 529 plan, you get some tax benefits. Some states allow you to deduct your contribution from your state income taxes (for us Floridians, with no state income taxes, that is not an option). Unfortunately, contributions are not deductible at the federal level.
The potentially bigger benefit comes in the way of tax-free growth. You can invest your contributions based on your comfort and goals. Your earnings are tax-free as long as the money comes out to pay for qualifying expenses. That tax-free growth is a big deal and the main reason to use a 529 plan instead of just investing in a personal investment account for the child’s education.
2. When Should I Start?
The key to savings is to do it consistently. Figure out your budget, plan the amount you can invest, and have it automatically deducted from each paycheck. Like with just about any investment strategy, time is your friend, and that is also true when using a 529 account. The earlier you start, the longer you get to experience the magic of compounding, and the more your savings can potentially grow. Remember, the average total cost of college can range from $10,000-40,000 per year, depending on which school. College gets pricey quickly. Starting early allows you to tackle that expense over time instead of all in one shot.
If you are within a year or two of using the money for college and just getting started, we would probably recommend a different option than a 529. Remember, the big benefit of a 529 is tax-free growth, and with a very short time frame, there is not much time to achieve growth.
3. What are the maximum or minimum amounts that I can contribute?
529 Savings plans follow the gift tax exemption rules. For a married couple, you and your spouse can contribute up to $16,000 per year each (in 2022). You can also bunch up to five years’ worth of annual contributions at once (i.e., you can contribute up to $80,000 at once).
Each 529 provider will have different minimums, but you will be able to find ones that have very low or even no minimums. For example, the Florida 529 savings plan has no minimum.
4. How should I invest?
All 529 plans have a plan manager, usually a financial services firm, that manages the portfolio of investments. You’ll be able to create a portfolio from an offering of mutual funds and ETFs, and tailor it to your time horizon and investment preferences. We suggest you match your investment selections to your risk tolerance and time horizon. Similar to investing for retirement, the further away from the expense, the account could be aggressive. The account should drift more conservative as you get closer to when you will need the money. We would not recommend investing in higher risk, higher potential return types of investments when the time frame is short.
Many 529 plans offer age-based or target date type funds, which may be an easy way for you to invest, as these would shift the risk automatically over time. Please research the investments available when starting; all age-based or target-date funds are not created equally. Reach out to a professional if you need some help.
5. What can I use the money for?
To withdraw money from a 529 tax and penalty-free, the funds must be used for qualified education expenses. Fortunately, all sorts of things are allowed, and that list expanded in the last few years.
You can use 529 for tuition and fees of both college or vocational fees (the total amount) and even k-12 expenses (up to $10,000) per year. College qualified expenses also include books, supplies, computers, and room and board. You can even use 529s to pay up to $10,000 (lifetime limit) of student loans. Here is a good article that further details qualified distributions.
Like any other goal, such as buying a home or investing for retirement, consistent savings and a solid financial plan can get you there. 529’s can be an important tool in helping you fund education expenses, but it’s not the only option. It is important that you do your homework to understand the rules and options. If you need help figuring out what is best for you, we are happy to talk.
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