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It's 529 day, and 68 percent of people don't know what a college savings plan is

  • Only 32 percent of people could correctly identify a 529 plan as an option for saving for college expenses.
  • Investment earnings in a 529 plan are not subject to federal capital gains tax and generally not taxed by state governments when used for the qualified education expenses.
  • Thirty-three states and the District of Columbia give tax breaks to residents who invest in their 529 plans.

Today is not just Memorial Day, it's National 529 College Savings Plan Day. The problem is that more than two-thirds of investors don't know what those plans can do.

Only 32 percent of people could correctly identify a 529 plan as an option for saving for college expenses, according to a new survey by the investment firm Edward Jones. The 1,009 people polled in mid-May did better than last year's group, which had just 28 percent who understood what these state-sponsored plans did.

These 529 plans offer many tax benefits that are better than using a savings account or, worse, tapping your retirement savings. Investment earnings in a 529 plan are not subject to federal capital gains tax and generally not taxed by state governments when used for qualified education expenses, such as tuition, fees, books, and room and board, of the designated beneficiary.

"The most important thing is to start saving and not wait for a rainy day." -Andrea Feirstein, founder, AKF Consulting Group

In addition, 33 states and the District of Columbia sweeten the deal by giving residents a tax break if they invest in their state's 529 plan. Five states — Arizona, Kansas, Missouri, Montana and Pennsylvania — offer a state income tax deduction to residents for any 529 plan contributions.

"The most important thing is to start saving and not wait for a rainy day," said Andrea Feirstein, founder of AKF Consulting Group, an advisor to 529 plan administrators in 33 states. "If you're grandparents, the day your grandchild gets a Social Security number, put whatever you can in a 529 plan. The tax-deferred compounding is more powerful than most people understand."

Despite the tax advantages, Sallie Mae, the largest private student lender, found that only 16 percent of parents used 529 plans or other college savings options for the 2015-16 academic year, down from 17 percent a year earlier.

Investors have opened 12.2 million 529 plan accounts with $266 billion in assets as of March 31, according to financial research firm Strategic Insight, up from 12 million accounts and $252 billion in assets at the end of last year.

"529 saving plans continue to reach year-over-year highs," said Paul Curley, director of college-savings research at Strategic Insight. "It's a relatively new product, started in 1996, and awareness is slowly growing among parents and grandparents."

Beyond the tax benefits, investors should know about the two types of 529 college savings plans: those sold directly by the states and those sold through financial advisors. (To make matters more confusing, there are also 529 prepaid plans that allow account holders to buy tomorrow's tuition at today's prices at in-state public colleges and certain private schools.)

Direct-sold 529 plans generally have lower investment fees than advisor-sold ones. However, advisor-sold plans tend to offer more investment options than direct-sold plans. "Fees matter, and we are seeing fees continue to come down for direct-sold 529 plans," Feirstein said.

Roughly 60 percent of assets invested in 529 plans are in age-based portfolios, which automatically increase their bond holdings to become more conservative as your child reaches college age.

The 2K rule

Fidelity Investments recommends 529 plan investors use the $2,000 rule.

Here's how it works: Multiply your child's age by $2,000 to stay on track to cover half the average cost of a four-year, public university. Under this strategy, if you have a 5-year-old, you would need to have $10,000, or $2,000 times 5 years, to be "reasonably confident" that you can afford roughly half of the cost of four-year, in-state public university.

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What JPMorgan CEO Dimon gets wrong about the student debt crisis

529 plan investors come close to Fidelity's 2K rule. The average 529 investor has more than $32,600 in their account when their child reaches age 17, according to data from Ascensus College Savings, which administers 34 college savings plans in 18 states and the District of Columbia.

More people are starting 529 plans sooner for their kids and grandkids than they have in the past, said Peg Creonte, senior vice president at Ascensus College Savings. A decade ago, about 29 percent of 529 plan investors had beneficiaries who were 1 year old or younger. Now about 36 percent of 529 plan accounts have beneficiaries in this age group.

"Too many people see the cost of college and have a real mental block that they are never going to be able to save enough, so they don't even start," Creonte said. "We need to do a better job of showing people how 529 plans can help them offset those expenses."

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