Tax-favored 529 savings plans allow families to manage the cost of higher education, yet few people understand how they operate.
May 29 marks 529 College Savings Plan Day, shining a spotlight on a savings account that allows families to save after-tax dollars, have them grow tax-free and then use the money to pay for qualified higher education expenses — such as tuition, fees and books — on a tax-free basis.
Every bit helps when the current price tag for tuition, fees, room and board at a private four-year college is $48,510, according to College Board estimates.
Despite the virtues of 529 plans, many people are still unfamiliar with the accounts.
Two of 3 people recently polled by Edward Jones were unable to correctly identify a 529 plan as a savings account for educational expenses. The financial services firm polled 1,002 people in April.
In fact, only 18% of respondents said they would use a 529 plan, while close to 40% said they would use a personal savings account and 35% said they would turn to scholarships.
In all, there was $339 billion in 529 savings and prepaid tuition plans as of the end of March, according to Strategic Insight.
When it comes to growing a 529 savings account over time, every bit helps — from your own contributions to the cash your child gets for holidays and birthdays.
"Even saving 1% of your income in a 529 plan might seem like a small percentage, but that 1% really does add up," said Paul Curley, director of college savings research at Strategic Insight. "As you get pay increases, you can increase the contribution, too."
Here are a few facts you should know.
1. Earn a state tax break
More than 30 states offer their residents a state income tax credit or deduction for contributions to college savings plans, according to SavingforCollege.com.
Families who aren't using 529 plans are missing out on their share of an estimated $237 billion in state and capital gains tax benefits and market growths, according to research firm Morningstar.
Tax incentives aside, there is no requirement that you invest in your home state's 529 plan. Be aware that even if the state you reside in will give you a good break for investing in its plan, you might find a better deal elsewhere if the costs are too high.
2. Know your costs
Lower expenses on the 529 plan you choose allows you to invest more of your contribution.
Families can purchase direct-sold plans themselves or they can opt for advisor-sold plans through a financial professional.
An advisor's expertise costs money. On average, advisor-sold plans had a fee of 96 basis points or 0.96%, according to fourth-quarter 2018 data from Strategic Insight.
On the other hand, direct-sold plans charged 44 basis points or 0.44%.
Investment fees can also vary sharply from one plan to another, said Curley.
For instance, age-based portfolios offered in Utah's direct-sold my529 plan range from 0.17% to 0.59%, while in New jersey, fees for age-based funds range from 0.41% to 0.91% in the NJBEST 529 plan.
3. Use the funds wisely
The Tax Cuts and Jobs Act allows families to use 529 plans to cover private K-12 tuition expenses.
The national average private school tuition is about $10,671 per year, according to Private School Review.
However, even though the federal government permits these withdrawals, your state might not agree.
In fact, a handful of states — New York, Oregon and Vermont —will hit residents with penalties or clawbacks of state tax breaks if those savers use 529 dollars for K-12 expenses.
Also, parents who start withdrawing money from their 529 for K-12 tuition are missing out on years of compounding interest.
4. There may be changes to the 529 program
There may soon be other ways to tap your funds.
The Secure Act, which sailed through the House earlier this month, would allow savers to take a distribution of up to $10,000 from a 529 plan to pay down student loans.
The proposed legislation would also allow savers to use their 529 funds to pay for fees, books and supplies in a registered apprenticeship program.
The bill now goes to the Senate.
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