529 plans are a special type of investment account to save for college expenses which shelters the money gained from income tax. In other words, while you have to pay income tax on interest earned in your savings accounts and gains of standard investment accounts, using a 529 investment plan to save for college lets you grow that money tax free.
When it comes to tax advantaged ways to invest money, and therefore have the opportunity let your money grow more money over a long period of time, a 529 is pretty attractive.
The catch is that you have to use the money for education expenses in order to take advantage of the tax free growth. If you don’t, you’ll have to pay tax on that money (like you would in a standard investment account) – and a 10% “penalty.”
This is where our minds go, “Whoa! Hold the phone… penalty? What if life happens and my child doesn’t go to college? What if they invent the next Amazon or Apple in the garage without a college degree?”
So the first step is to quantify that cost so we can put the ‘risk’ of this investment in perspective.
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Beware of loss aversion bias
This is where it’s helpful to understand a bit about how our brains work & loss aversion bias. Humans tend to have a stronger aversion to losses than we have appetite for gains. It’s a bias that makes us extra wary of things like “10% penalty” even when we’re facing a high probability of a 20% gain by avoiding taxes.
The cost of not using the money saved & invested in a 529 plan for education expenses is paying taxes (you’d have paid anyway) and a 10% fee on the gains of your 529 investment (note, the penalty rate doesn’t apply to your contributions – the money you put in yourself).
When deciding whether to invest using a 529 plan, try quantifying the best case and worst case scenario. Use a compound interest calculator to estimate your particular situation.
Here’s an example scenario:
You contribute $10,000 of hard earned money over the years to a 529 investment for your child’s benefit. It gains $6,000 by the time your child is 18 for a total of $16,000. This is all assuming your investment would gain over time – which is a relatively safe bet over a long period of time in the U.S. stock market. BUT it’s not a guarantee.
Best case:
You have $16,000 in full to use towards your child’s college expenses. You can withdraw your original $10,000 without taxes or fees regardless of what you use it on (you already paid income tax on that money when you earned it in the first place, remember?) And that new, free $6,000 you gained is also there for the taking if you use it for your kid’s college, tax free.
Worst case:
For whatever reason you will not be able to use that money for an approved education expense. Again, the $10,000 in contributions is yours regardless, no taxes or fees there. And now you have a free $5,400 (6K in growth less the 10% penalty) that you must pay income tax on. So, let’s say after paying taxes it’s more like $4,200 that’s yours for the taking.
In either scenario, you made an investment that gained free money, either $4,200 or $6,000, depending on the scenario.
Either scenario is a win because you invested. And that leads us to the real question…
The real question: opportunity cost
So now that we’ve put the 10% penalty in perspective, it’s time to look at this decision as a question of opportunity cost. And this means any family really needs to compare investing in a 529 plan to what they would be doing with that money otherwise.
If you didn’t invest in a 529 plan, what would you do instead with that money?
Nothing, just the usual paying for life stuff
- no growth, no money left to speak of
If your likely alternative to investing in a 529 plan is to just keep calm and carry on, the 529 plan wins the day. Money spent on non-assets no longer exists in the future and gains nothing.
So, if a 529 plan is a way to get motivated to invest in this special way to prepare for your child’s future when you wouldn’t have done anything else otherwise, it may be a very good move you’ll thank yourself for later.
Cash savings
- no appreciable growth
- ‘gains’ are taxed (but barely appreciable at today’s savings interest rates)
If you’re thinking of just stashing the same money away in a savings account, even a high yield savings account, the math is a little different. The money will not grow (at today’s abysmal low savings interest rates) any appreciable amount. And any ‘gains’ you do have will be taxed.
This approach will protect against any possibility of loss since you can make sure you pick a savings account that is FDIC insured. But as long as there is enough time to absorb market volatility (i.e. money invested is always at risk of loss, but time lessens this risk), a 529 plan will still probably win out in the long run over stashing cash in a savings account or under the mattress.
It’s irrelevant to talk about avoiding a penalty in this scenario because there are no real gains to speak of to begin with. It’s better to have gains that lose 10% than no gains at all.
Traditional investments/real estate
- invested to grow
- gains are taxed
This requires some calculating and personal judgement. Likely a 529 plan will still win out if it’s quite probable that you will have a use for approved expenses someday.
For many people, having a mix of traditional investments and still putting some money in a 529 plan might make the most sense. You don’t have to make an either/or decision.
Personally, we look at our rental property as our college savings. The loan is slowly getting paid off by rental income, the home appreciates over time curbing the impact of inflation. And we put relatively little of our own money in, along with our time and effort to manage the property. Down the road we have the flexibility to sell the property (and pay taxes, by the way) to reinvest in a different way, use all the money for college, or keep the property and use rental income to help pay for college in real time because the mortgage will have been paid off by that time.
529 investment
- invested to grow
- gains are tax/penalty free when used for educational expenses (your contributions are always penalty free & you already paid the tax)
Here you enjoy the benefits of growth through investing but gain a substantial advantage of withdrawing that money tax free for an expense that is quite probable – most students go to some form of higher education and that rate is climbing. Just look at your tax bracket rate and consider that a discount against your 529 gains.
By comparison, think about insurance plans… you buy the peace of mind, or the opportunity to be taken care of in an unlikely, unwanted situation (like car accident, illness, or premature death). And we pay premiums every month to cover ourselves for those possibilities.
College is actually way more likely than any of those undesirable scenarios. So, for something you generally expect to happen, it makes sense to prepare even if you’re putting some free gains at risk of a 10% fee in the future.
Retirement investment
- Invested to grow & growth is maximized thanks to longer time
- Contributions or withdrawals are tax free (but not both)
Ooooo, here’s where it gets interesting!
For most, the most bang from your invested buck is in your retirement plan (investing in a health savings account available to people with high deductible health plans is the only other more tax advantaged place to invest). Here you can choose to either pay tax on your contributions and withdraw tax free later (Roth plans), or vice versa (traditional plans). But you can’t start pulling money out until around age 60 – and then you can use it for whatever you want.
Here’s the important part – there’s no loan program for retirement. But there’s plenty of way to get loans for college.
Plus, investment growth in a retirement plan will capitalize on the factor of greater time. Money in your retirement plan(s) will grow decades, compared to money you’ll use sooner for a child’s college. And time drives compound growth.
So if it’s between putting more money in your retirement plan and a 529 plan, run some compound interest scenarios, know your numbers, and make sure your retirement is well taken care of before any college savings plan.
Might be for you?
Get your state specific details
When you decide to start one of these plans, seek out details that vary by state. Many states offer additional tax benefits on top of the federal tax benefits mentioned above that apply to all 529 plans. Technically, you don’t have to purchase your own’s state’s plan, so you can strategize where you shop your plan as well. Here’s a nice article that can highlights state-specific details.
Learn all the approved uses
We’ve been talking about 529 plans as they apply to college expenses generically. But these plans can be used for a variety of post-high school educational expenses, and even for K-12 private education costs. Beneficiaries can also be changed, so if your child doesn’t use the money, perhaps you or another person in your family will.
Understanding the array of caveats for what 529 plan dollars can and can’t pay for will give you a sense of the flexibility of allowed expenses on these accounts as well.
Final words
No one knows the future. If income taxes go up, tax advantaged investments become even more valuable. If college expenses go down, special investments become less valuable. If the market crashes at the wrong time and your investments are impacted, you could lose money.
The thing is you make a decision that feels right to you now and you can change course if you need to. I always like to follow my gut and then just commit to that decision and do my best on that path. Get informed, make adjustments along the way.
Oftentimes, being stuck in indecision and taking no action is generally worse than taking no action at all – for fear of picking the “wrong” thing. Whatever your choice, it will be the right one for you.
Thoughts on 529 plans? Please share them in the comments below. 👇
Please note I am not a financial professional. The information contained in this post is intended to aid the decision making process in the context of different forms of saving for the future. You are responsible for understanding the details, risks, benefits, and tax implications of investing with your money.