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WE PUT OUR TWO KIDS through college using 529 plans—and I estimate the accounts easily added 10% to the value of our college savings, compared to what we would have accumulated if we’d invested through a regular taxable account. Yet only 37% of families use 529s to help pay for college, according to a 2021 survey by Sallie Mae.
Like an IRA, a 529 plan gives you a tax break for saving for a specific goal—but, in this case, college rather than retirement. Money in a 529 grows tax-deferred and, if used to pay for qualifying education expenses, can be withdrawn tax-free.
You don’t get a federal tax deduction for funding a 529, like you can with a traditional IRA or 401(k). Several states, however, do give a state income-tax deduction, including Pennsylvania, where we live. Pennsylvania’s state income-tax rate is 3.07%.
Each year, Pennsylvania allows residents to deduct up to the gift-tax exclusion—$16,000 in 2022—for contributions to any 529 plan in the country. Other states provide a deduction for in-state plans only, which limits your choice. At the end of this article, I’ll offer some suggestions for finding a good plan.
We used Utah’s 529 plan because it had rock-bottom fees, offered low-cost index funds and didn’t charge a sales commission. We invested in lifecycle funds that started stock-heavy when the kids were young, then switched to a majority bond allocation as college neared.
When we took withdrawals, we owed no federal or state taxes because all the money was spent on qualifying education expenses. If you’re keeping score, this means 529 plans potentially offer a rare tax triple play: tax-deductible contributions at the state level, tax-deferred growth and tax-free withdrawals.
This tax trifecta is shared with only one other investment account that I know of—health savings accounts. HSAs are a bit more valuable, however, as they confer a federal income-tax deduction on contributions, rather than solely a state income-tax deduction, which is what we got for our 529 contributions.
Qualifying education expenses include the basics—tuition, room and board. They also include anything required by the school, such as books, equipment and fees. I imagine a personal computer is required equipment for today’s college students. A dorm room fridge or a puffy jacket, however, wouldn’t make the grade.
There was one more way that we saved thanks to 529 plans. For a decade, my wife and I carried credit cards that paid a cash reward to our kids’ 529 accounts. The Upromise card’s reward equaled 1.5% of each month’s credit card charges. We paid off the card’s balance in full each month and transferred the reward dollars to our kids’ 529s. Over a decade, the card’s reward payments added more than $3,000 to our family’s 529 account balances.
Even with our 529 savings, paying for college was a long, hard slog. We paid tuition for eight straight years. Our kids graduated without any debt. They now have good careers and lead happy, independent lives. To us, that’s the whole purpose of education.
If you’re saving for college, shop carefully for your 529 plan. Morningstar ranks the plans once a year, awarding them gold, silver and bronze medals. The Utah 529 plan we used still gets a gold medal, one of only three that Morningstar bestowed in 2021. Check to see if one of the prize-winning plans is offered in your state.
Meanwhile, you can research your state’s 529 tax breaks using SavingforCollege.com. We were lucky with Pennsylvania’s 529 rules. Many states are less generous. If your state’s plans don’t seem like a good fit and there’s no special state tax break for funding them, don’t force it. Instead, check out the plans from other states.
If you decide to open a 529 account, try to stick with a direct-sold plan. These are analogous to no-load mutual funds. The 529 plans sold by brokers tend to be more like load funds and charge higher costs.
Some people have told me they’ve held off saving in 529s in the belief it might hurt their child’s chance for a scholarship. Perhaps, but I don’t think this is a big risk. Money in a 529 account opened by a parent isn’t heavily weighted in the college aid formulas.
If your child does get a full ride to college, you can transfer money in a 529 account to another family member. You could even spend the money by going back to school yourself. New rules also make money in a 529 available to pay for K-12 education or to repay up to $10,000 in student loan debt.
If you don’t use your savings for eligible expenses like these, and instead make withdrawals for some other purpose, you’ll owe a 10% tax penalty and income taxes on the account’s investment gains, but not on your original contributions. If you’re worried about overdoing it, you might limit your 529 savings to perhaps half of what you expect your child’s college education to cost.
Of course, you may not need to save in a 529 if your child can run a four-minute mile or is a lock to be admitted to a national military academy. As for the rest of us, I suggest starting to save as early as possible. After all, as almost everybody will tell you, kids grow up fast.
Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.
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Thank you for writing this article on such important topic, Greg!
My wife and I have 529 Plan for each of our two boys. It has been one of the best financial decision we’ve made so far, and we’ve consistently made monthly contribution. With our older one starting 5th grade tomorrow and younger one starting 3rd grade, I hope our 529 Plan will still have plenty of time for compounding and growth before their college freshman year.
We also use the Utah 529 plan, but to help with the college expenses of our grandchildren. So far, the growth in the accounts has paid for about 35% of the expenses. And, when they graduate, if there are funds remaining, they can be used for grad school, or the beneficiary can become the owner and use the funds for their children’s education. So, the 529 can become a multi-generational tool.
I was once audited by the IRS (they ended up owing me $3) but I was surprised to find one of the issues was I had to prove that my daughter is my daughter, as I had paid for her college with 529 proceeds. My proof documentation was accepted. Now the same government that made me jump through hoops to claim our daughter is our daughter is going to transfer $10,000 or $20,000 in student loan debt from those who took out the loans and agreed to pay them back, to the rest of us taxpayers. Great…
I have twins who are in their sophomore years now. Because we were older parents and had more saved, in and out of retirement plans, and now that I am widowed and the student aid formula is based on its calculations of how much I can spare and how long I’ll live, I am paying a lot each semester.
My plan was have my students forego federal loans and graduate debt free. Now I am hedging my bets and having
them take out some loans. My kid in art school is more unlikely to hit whatever means test they’ll establish when it’s her turn to get loan cancellation…. And no one from
the government is going to drop by with $10,000 or $20,000 to help pay my expenses as an oldster, assuming their calculations of what I’ll need
later are wrong.
Does anyone believe this loan cancellation is a one-and-done deal?
Unfortunately the cost of paying for hundreds of billions in benefits has to be borne by someone.
Today’s loan cancellation goes to former students who will have the whole value of their college education, the cost being borne by many people who paid for their education.
I think many people don’t believe anymore that college is worth the time and money it takes to earn a degree. The cancellation is one way for the government to put a finger on the scale.
I don’t know how the IRS is handling 529 plan distributions these days, but I know what I experienced in 2008-2010. These plans came about after our oldest 2 kids had gone to college but before our 2 youngest did. So we started 529s for the younger ones.
The 529s were a big help in funding college but I got a rude surprise when I received a letter audit from the IRS three years in a row. There had been no place on my return to list how the distributions were spent. So now the IRS simply assumed that all the distributions were for non-education expenses and the burden was on me to prove otherwise.
Fortunately, I had kept good records, but several weekends were ruined preparing my item-by-item response detailing how each withdrawal had been spent, with exhibits consisting of copies of all receipts.
I hope there’s a better way in place now.
Worked my tail off to get my two through debt free (many years ago – pre 529) When someone would ask why I was doing it I would say “I’m buying insurance” …and they would inquire what kind of insurance??? And I would reply “Insurance that they won’t end up living in my basement”!! Both educated successful student loan free adults … now I may become acquainted with a 529 for the grandchild
When they began, 529 plans were loaded with fees. Instead, we used education IRAs with index funds at Vanguard. And they paid off. Thanks to the bull market after 2008, they were well worth it.
They did not impact merit scholarships. I have no idea how they would impact need-based scholarships. (Our FAFSA story is a whole other issue…)
And this raises questions about college costs in general, which has been discussed in this newsletter. And the impact of wealth disparities on educational opportunities and choice.
It’s worth mentioning the liberalization of 529 plans rules governing eligible disbursements that occurred as a result the 2017 tax reform act. Funds can now be used for private K-12 schools as well, up to a 10K maximum annually. I have seen parents roll 10K into their 529, then take the funds back out in short order to pay for private school, thereby capturing a state income t