The Best Way to Save for College
This past June, Kelsey’s sister, Kacey, gave birth to John Louis III A.K.A. JJ. Although I already have four nieces and nephews, he is Kelsey’s first nephew and we were so excited to meet him! I started thinking about how he’s going to grow up and what I could do to help him succeed. One of the biggest struggles for anyone with children is how to pay for education. In celebration of his birth, let’s see what the best way to save for his future would be.
Up to this point, I’ve written mostly about retirement savings. One of the big themes for retirement savings is managing your taxes effectively. Doing so can result in having thousands more dollars than you otherwise would have had. The same goes for saving money for your kids, particularly for college.
Congress recognized this need and created a few different tax-advantaged accounts that you can use. The most common type of account is called a 529 plan. Just like 401(k)s, 529 plans are named after the section in the IRS tax code where they were created. These are special accounts/plans you can open and fund for the purpose of saving for educational expenses. You can open these accounts through various brokers but most states also allow you to purchase and setup the accounts directly through the government.
529 plans work similarly to IRAs in that earnings in the account are tax-free. So you can avoid taxes on any profits and dividends from assets in these accounts. They also share the tax-free withdrawal like Roth IRAs so when you take money out, you don’t have to pay any taxes. But in order to get the tax-free withdrawal, you have the spend the money on “qualified education expenses”. These can include tuition and fees at an accredited educational institution as well as supplies associated with attending such as books, laptops, and software. As of 2018, you can also use up to $10,000 of funds for tuition at private elementary and secondary schools.
Each state sets up its own 529 plan. There are some national 529 plans as well but the vast majority of them, and the best ones, are setup directly by the states. Since plans are specific to each state, the details of each plan will vary slightly so make sure you understand the details of the specific plans you’re interested in.
You generally don’t have to be a resident of the state to purchase the plan but sometimes, it’s advantageous to go with a plan in your state. Many state plans allow residents to deduct contributions from their state income tax. Additionally, while most plans will allow you to use the funds at nearly any educational institution, some plans will restrict the use of funds to state colleges. Again, you should review the details of the plan you’re interested in.
Types of Plans
529 plans can be generalized into two different types: general savings plans and prepaid tuition plans. General savings plans are essentially investment accounts, similar to 401(k)s, where you can invest in various mutual funds deemed appropriate by the state. Again, the advantage is that any dividends or profits from your investments are tax-free within the account.
With a prepaid tuition plan, you purchase school credits or units instead of shares in mutual funds. The future value of these credits/units is directly tied to the average cost of tuition. So instead of your investment performance being dependent on the market, it’s tied to the rate of inflation for tuition.
The advantage to a prepaid plan is that you’re locking in today’s educational rate. Since tuition generally rises faster than inflation, paying today for education will result in paying less in the long run, even when accounting for inflation. Depending on which measure you choose, tuition rises between 6–10% each year! When we compare that to the 3% general inflation, using a prepaid plan doesn’t seem like such a bad idea.
Prepaid tuition plans are backed by the states, so they’re generally less risky than investing in the market in a general savings plans. But the average market return over the past 50 years is over 9%, so you would likely have better performance in a general savings plan. The right account for you depends on your risk tolerance and what kind of return you’re looking for.
So who can open and contribute to a 529 account? There are no income restrictions on 529 accounts, so anyone can open an account. In addition, you can name anyone as a beneficiary, whether they’re your child, friend, or even yourself. A single person could be named the beneficiary on several different 529 accounts.
In terms of how much you can contribute, the law specifies that you can’t contribute more than is necessary to cover education expenses. Each plan determines this limit but it’s typically very high (since college is very expensive) so you likely don’t need to worry about this.
Penalties on Withdrawals
You only get the benefits of 529s if you use the funds for education. What if you don’t spend the money on “qualified education expenses”? What if your child decides they don’t want to go to college?
You have the option to change the beneficiary once per year, so you can always do that if you find your child isn’t interested in higher education. When changing the beneficiary, the new beneficiary has the be related to the previous beneficiary, out to first cousins.
You could also withdraw the money and use it for something other than education. If you do that, the profits count towards your taxable income and would be taxed at your current tax rate. In addition to that, you’d have to pay a 10% penalty on profits and earnings. And on top of that, if you received any state tax deductions, you’d likely have to pay those back as well. With all of those penalties, using money in a 529 for non-educational expenses can cause you to lose a large chunk of your change.
Alternatives to 529s
If you’re using the funds for education, using a 529 is a no-brainer. I like the tax advantages of 529s, but the penalties for using it on non-educational expenses aren’t trivial. Let’s take a look at other options for college savings.
Before 529s came around, the most common way to save was US Savings Bonds. Theses are bonds from the US Treasury that come with the same tax advantages as 529s. Interest earned on the bonds is tax-free when used for education. But your tax benefit will get reduced if your income is too high (single, $77,201; married, $115,751) and at a certain point, you lose the tax benefit altogether (single, $91,999; married, $145,749). The return is also paltry when compared to investing in 529s. The current interest rate for bonds is 0.1%! You could easily get a return 50 times higher in a 529. There’s a good reason savings bonds have fallen out of favor.
Educational Savings Accounts
The next alternative is Education Savings Accounts or ESAs. These accounts again offer tax-free growth on investments and you have to pay taxes and a 10% penalty on withdrawals for non-educational expenses. The difference is that in ESAs, you can invest in anything just like a general investment account whereas in a 529, you have to choose from a curated list of mutual funds.
ESAs provide more investment flexibility but they also have more restrictions on who can use them and how much you can contribute. You can only contribute $2,000 per year to an ESA and that contribution limit starts to decrease if you make more than $95,000 per year if you’re single ($190,000 if married). At a $110,000 single income ($220,000 if married), you can’t contribute to an ESA at all. Compare this to 529s that have contribution limits in the 6 figures with no income limits. Once the beneficiary reaches 18, you can’t contribute any more money to the account and, if you don’t change the beneficiary, the funds have to be distributed before the beneficiary turns 30.
Another option people will often explore is using an IRA to save for college. IRAs are typically reserved for retirement and funds taken before you turn 59½ are subject to a 10% penalty. But you can skirt this penalty if you use the funds for educational expenses (among other exceptions).
If you use your IRA to fund your child’s education instead of your retirement, you may end up being more of a burden to them in old age. IRAs only have contribution limits of $5,500 per year ($6,500 if age 50 or older). If you use even a small portion of that for college, you may not have enough funds for retirement. In terms of personal finance, your retirement should take precedence over college. If you can’t fund your child’s education, they can take out loans and get assistance from a ton of different sources. If you can’t fund your retirement, you either have to hold off retirement indefinitely or rely on relatives for funds. I don’t recommend this.
You might be thinking “what if I open an IRA for my child”? That works, but only if your child has income. You see the contribution limit to an IRA is actually your taxable income or $5,500 per year, whichever is lower. Since most children won’t have any taxable income to report, you can’t contribute to an IRA in their name.
Taxable Investment Accounts
Finally, you could consider a good old taxable investment account. Taxation on long term investment profits is generally pretty good. If you’re single and make less than $38,701 ($77,401 if married), then you don’t have to pay any taxes on your profits as long as you held your investments for more than a year. If you make more than that, your profits will still only be taxed at 15%. Compare this to using your 529s for non-educational expenses where you have to pay taxes according to your tax bracket and pay a 10% penalty on top of that.
Of all the different alternatives to 529s, I think the taxable investment account is the best option. Your taxation in a taxable investment account isn’t as good as the 529, but you’re not tied down by any penalties. You also have more flexibility with how much you can put in and how you eventually use the funds.
Crunching the Numbers
As I mentioned, if you’re going to use the funds for education, a 529 is by far the best option. Let’s see how using a 529 plan could help little JJ in the future.
We’ll say Kacey opens a Pennsylvania 529 general savings plan for JJ. She’s going to put in $200 per month for 18 years. Since Kacey is also a PA resident, she gets to deduct her contributions made to 529 accounts. She’ll go ahead and put those tax savings right back into the 529 account. Kacey is going to invest in mutual funds that cover the broad market and average a return of 7% annually.
With this setup, when JJ’s ready for college after 18 years, Kacey’s put in about $43,000 but has just over $90,000 saved for JJ to use for college! That’ll be enough to cover most, if not all, of a 4-year education at that point.
But then JJ tells Kacey that he wants to move to Hollywood and be an actor. He doesn’t want to go to college.
Well darn… What to do now…
If Kacey were to take the funds out of the 529 account now, she would have to pay $15,000 in taxes and penalties, leaving her with about $75,000. Kacey decides to leave the funds in the 529 account. She ends up retiring after having the account for 30 years and uses funds from the account to cover some expenses. She starts pulling $1,500 from the account each month. When she does this though, she pays taxes on the profits at her tax rate of 22%, pays back her state tax she previously took as deductions, and pays a 10% penalty on profits. Still, she’s able to pull funds from her account for 13 years.
So let’s rewind and see what would have happened if Kacey went with a taxable investment account instead. Again, Kacey will contribute $200 per month. She’ll invest in mostly the same stuff, getting a 7% annual return.
This time, when JJ is 18, Kacey has just over $80,000 to use towards his education. $10,000 less than she had when going with the 529.
But when JJ tells her he doesn’t want to go to college, Kacey still has $80,000. Since it’s a taxable investment account, there’s no additional penalty for using the funds for non-education purposes.
As you can see, her 529 was worth a lot more than her taxable investment account when she was going to use it for qualified expenses. But as soon as JJ decides he doesn’t want to go to college, all those extra taxes and penalties cause the 529 account to lose value when compared to the taxable investment account.
With the taxable investment account, she does the same thing as before and holds onto the account for a total of 30 years. This time, when she starts pulling money out, she only has to pay 15% tax on the profits. Doing this allows her to keep withdrawing funds for 15 years. The account lasts a whole 2 years longer than before!
Which Account is Right?
In my previous articles, after running the numbers, there was a pretty clear cut winner. But this week, there are pros and cons to using either a 529 account or a taxable investment account. I played around with a few different numbers and I couldn’t find a realistic scenario where one option was clearly better than the other.
If the funds are eventually going to be used for education, the 529 is clearly the better path. But no one can tell the future and if you end up needing the funds for non-educational purposes, the taxable investment account gives you more bang for your buck.
After doing the research, my wife and I talked awhile about what we plan on doing for our children. We finally decided that it would be worth it to us to open a 529 account. We figure it’ll be a good motivator for our children if they know that we opened an account specifically for them and the funds can “only” be used for education. The funds can be used at four year universities, two year community colleges, and trade schools so our kids will likely need the funds for some sort of education. If all else fails, we can use the funds in retirement to take courses at the local community college. We’ll be the old couple sitting in the back.