Should I Start a 529 (College Savings) Plan for My Child?

As a parent, one of the hot topics in personal finance that you’ll often see discussed is saving for your child’s college education.

While some parents prefer to save their child’s college fund in a glass jar or underneath their mattress, there are certainly a lot of better options out there: one of which is a 529 Plan.

(Whether or not you think saving for your child’s college tuition is a good idea is a separate discussion – I discuss that here.)

The 529 plan sounds a lot more confusing and intimidating than it is, and I think that’s why some people ignore it.  And you don’t need to hire a CPA or a financial adviser to set one up – it’s actually quite easy to do yourself.

What is a 529 Plan and Why Bother Opening One?

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs.  The key word being: tax-advantaged.

But what does “tax-advantaged” even mean?

Saving for college is about more than just putting $1 away today so that you can spend that $1 on college tuition 18 years from now.  What you’re hoping for is that your $1 saved today is worth $4+ when you withdraw it in 18 years.  You’re looking for growth.

Under normal circumstances, when you invest money and it grows, you pay tax on that growth when you cash out your investment.  But with a tax-advantaged 529 plan, the earnings on your investment can be withdrawn tax-free, provided it’s used for qualified education expenses.

In addition to tax-free growth, there are some other great benefits (some of which apply to college savings in general, not necessarily just 529 plans):

1) You don’t need a beneficiary immediately.

No child? No problem. Even if you’re planning on having kids but haven’t actually had one yet, you can still open a 529 account and begin saving right away (that’s what we did about a year before our daughter was born).

You can open an account in your own name, and later change it to your child’s name after he or she is born.  Or, you know, you can go back to school and use the money to get another degree.  And when your son or daughter asks about money for college, you can point to the wall and show them that you have two degrees.

2) It’s a good way to “automate” savings.

In addition to being able to start early (before your child is born), most 529 plan accounts allow you to automatically deposit money each month – just set it up and it’ll debit whatever bank account you specify.

I’ve personally found this to be really helpful because I otherwise would forget to periodically make deposits.  And it’s psychologically easier to do a little at a time (instead of depositing several thousand dollars all at once).

I’m a big fan of automating savings because of the way it helps you build a substantial balance.

Let’s take a look at an example:

Assume you start 2 years before your child is born (i.e. 20 years before they go off to college) and you deposit $100 per month.  Every year, you increase your monthly deposit by $20 (so in year 2, you’re depositing $120/month).  Also assume your money grows at a rate of 5% annually (because you’ve invested it in a relatively safe investment).

Look at what happens to your account balance over the course of 20 years:

Year	Total Deposit	Growth	Ending Balance
1	1,200	–	1,200
2	1,440	60	2,700
3	1,680	135	4,515
4	1,920	226	6,661
5	2,160	333	9,154
6	2,400	458	12,011
7	2,640	601	15,252
8	2,880	763	18,895
9	3,120	945	22,959
10	3,360	1,148	27,467
11	3,600	1,373	32,441
12	3,840	1,622	37,903
13	4,080	1,895	43,878
14	4,320	2,194	50,392
15	4,560	2,520	57,471
16	4,800	2,874	65,145
17	5,040	3,257	73,442
18	5,280	3,672	82,394
19	5,520	4,120	92,034
20	5,760	4,602	102,396

If everything goes as planned (keep in mind, there are several variables that would impact the outcome of the scenario illustrated above), you’ll have over $100,000 to put toward your child’s education by the time he or she goes to college.

Whether or not that’s enough 20 years from now is a separate issue – but either way it’ll be a nice chunk of change to go along with whatever grants, scholarships, and/or loans your child obtains.

3) It keeps you disciplined.

If you were just setting aside money on your own (in a regular bank account or wherever), you always run the risk of using it for other purposes.  The nice thing about the 529 plan is that you must use the funds for higher education expenses (more on that below), so you won’t be tempted to withdraw the money for other purposes.

Because of this restriction, using a 529 plan to save for your child’s education helps keep you disciplined and makes it more likely that the money will eventually end up going towards tuition (and not towards your midlife crisis car).

4) It offers possible state tax benefits.

This can vary from state to state, but in many cases, if you invest in your state’s own 529 plan, the state may offer a tax break on your personal income tax return.

In Illinois (where I reside), my wife and I can deduct up to $20,000 per year from our state taxable income if we contribute to the state sponsored 529 plan.  What this means is, let’s say we earn $200,000 per year and contribute $20,000 to our daughter’s 529 plan, the State of Illinois will only tax us on $180,000 of our income.

This is a pretty nice perk, in addition to the tax-free growth the money will earn after you’ve contributed it.

Here’s a site that gives you the state sponsored plans by state.  You should discuss with your tax professional whether contributions made to these plans are deductible for state income tax purposes.

Are There Any Drawbacks to Saving with a 529 Plan?

Like any good deal, there’s always a catch.

Fortunately, the main catch here is pretty straightforward and reasonable: once you put in money to save for college expenses, that money must be used for eligible college expenses.

If you withdraw the money for some other purpose, you’re going to pay a penalty on the amount that the plan has earned (your regular income tax % + 10% penalty).  So if you contribute $20,000 and it grows to $30,000, you’ll be paying tax + penalty on that $10,000 gain.

There are some other disadvantages as well, however I don’t believe any are significant enough to scare you away from using a 529 plan:

• Investment options may be limited – Unlike a 401(k) or other type of investment account, you likely won’t have a full array of investment options (various mutual funds, index funds, etc.).
• Some 529 plans have expensive fees – When selecting your plan, do some research to see what the plan’s expense ratio is (i.e. what % of your investment will be charged in the form of fees).  Like most other investments, there are fees based on how much you invest, so it’s just a matter of making sure the fee isn’t too expensive.  Based on the research I’ve done, anything around 0.5% or less is decent.
• Losses can occur – As with most other investments, your money is technically at risk. However, 529 plans generally offer relatively safe investment options that are expected to grow over a long period of time (i.e. maybe your investments could lose money in a 6-month period, but over a period of 18 years you can generally expect the investments to grow in value).

What are My Alternative Savings Options?

When you’re saving for college, 529 plans are obviously not the only option, especially if you want the flexibility to use your investment earnings for non-college related expenses in the future (without paying a penalty).

Here are some other options:

• Keep the money in a regular savings account – Although the money won’t be at risk, and you have the flexibility to use it however and whenever you want, you miss out on a lot of other benefits (as explained above).  Aside from losing the ability to grow your money tax-free, I think the biggest drawback here is that people tend to have a hard time not touching a large sum of money for 18 years (especially when it’s so easily accessible as it would be in a regular savings account).

• Stocks/mutual funds/etc. – The primary benefit with these types of investments is that you have flexibility AND a higher potential for growth, but it comes at the expense of risk (and any growth is taxed).

• Cash underneath your mattress – I sincerely hope you don’t save the funds for your child’s education in a piggy bank or “under your mattress.”  Not only is this incredibly risky, but your money won’t grow and will most likely end up being spent on something else.

The Bottom Line

Everyone’s situation is different, so I’m not going to sit here and call you stupid if you don’t think a 529 plan is for you.  Personally, I think it’s a fairly safe way to secure your child’s future education, and it’s something we’ve done for our daughter.

With that said, there are risks with any option you choose.  What if your child decides not to go to college? What if you suffer a financial crisis and need the money? You’ll still have access to it, but remember, there’s that 10% penalty on anything your investments have earned (+ paying regular income tax on it).

If you’re really struggling to figure this one out, speak to a financial adviser or do some further research online.  There are a lot of great resources that take this topic into much greater depth (by people who are experts in this area).

What do you think about using a 529 plan to save for your child’s future college education? Is there a different way of savings that you prefer? Leave a comment! 🙂