A 529 plan can be a powerful tool for funding education while making your money work harder through tax-efficient investing. But like any financial product, it’s essential to understand both its benefits and limitations before diving in. Let’s break down why you might consider setting up a 529 plan, provide some hypothetical scenarios to illustrate its potential, and examine the pros and cons.
Why Set Up a 529 Plan?
The primary purpose of a 529 plan is to help families save for education while leveraging tax advantages and the power of investing. Unlike keeping your savings earmarked for education in cash, which might lose value over time due to inflation, a 529 plan gives your money the potential to grow over the years.
Key reasons to consider a 529 plan:
- Growth Potential: Historically, investments have outperformed cash over long periods*. Investing allows you the opportunity to build a larger fund to cover qualified education expenses.
- Tax Efficiency: Earnings in a 529 plan accumulate tax-deferred and can be withdrawn tax-free if used for qualified education expenses. Non-qualified withdrawals are subject to taxes and tax penalty
Hypothetical Scenarios
Let’s explore two examples to demonstrate how growth potential can work to your advantage when saving for education expenses:
- Consistent Monthly Contributions
- Contribution: $500 per month
- Timeframe: 18 years
- Average Annual Return: 6%
Outcome: After 18 years, the account could grow to approximately $191,000. This includes $108,000 in contributions and $83,000 in investment growth.
- Lump Sum Contribution
- Initial Contribution: $95,000
- Timeframe: 18 years
- Average Annual Return: 6%
Outcome: After 18 years, the account could grow to approximately $271,000. This reflects $176,000 in growth on the initial contribution.
These examples highlight the importance of starting early and the impact of compounding over time.
These examples are for illustrative purposes only and are not representative of any specific product or investment. The examples do not reflect the deduction of fees and charges inherent to investing. Investment returns will fluctuate such that a stable rate of return like that used in the examples may not be achieved or maintained. It is possible to lose money.
Pros of 529 Plans
- Tax Advantages
- Earnings accumulate tax-deferred.
- Withdrawals for qualified education expenses are tax-free.
- State Tax Deductions: Many states offer tax deductions or credits for contributions to a 529 plan, depending on your state’s rules and your income level. For example, some states allow deductions of up to $10,000 for married couples filing jointly. Be sure to check your state’s specific guidelines to maximize your benefits.
- New Roth IRA Rule
- Starting in 2024, the Secure 2.0 Act allows unused funds (up to a $35,000 lifetime limit) to be rolled over into a Roth IRA for the beneficiary, providing a unique long-term benefit. Keep in mind that there are certain requirements that must be met to qualify to rollover funds, so it is important to work with a tax advisor.
- Transferable Funds
- Funds can be transferred to a qualifying family member of the current beneficiary if they don’t use all the money.
- Multiple Contributors
- Parents, grandparents, and other family members can all contribute to the same account, making it a collaborative savings effort.
- High Contribution Limits
- 529 plans allow for significant contributions, which can be up to $300,000 or more per beneficiary (varies by state). Keep in mind that there could be gift tax consequences so ensure you work closely with a tax advisor before making sizable contributions.
Cons of 529 Plans
- Lack of Flexibility
- Funds must be used for qualified education expenses to retain their tax advantages. Non-qualified withdrawals are subject to income tax and a 10% penalty on earnings.
- Impact on Financial Aid
- Assets in a 529 plan are included in the FAFSA calculation, potentially reducing eligibility for need-based aid.
- Market Risk
- Funds invested in the market can fluctuate, which may impact the overall value of the account if the market underperforms, especially near the time of withdrawal.
- Even shifting to bonds near withdrawal isn’t risk-free, as seen with the bond market decline in 2022.
- State-Specific Rules
- Tax benefits and contribution limits vary by state, so it’s important to understand the rules of the plan you choose.
Summary
A 529 plan can be a valuable tool for families looking to save for education expenses in a tax-efficient manner. It offers growth potential, significant tax advantages, and flexibility in transferring funds or rolling over unused amounts into a Roth IRA. However, it’s crucial to weigh the lack of flexibility, potential FAFSA implications, and market risks when deciding how much to invest.
By understanding the pros and cons, you can make an informed decision about whether a 529 plan fits into your overall financial strategy.
* Past market performance is not a guarantee or reliable indicator of future results.
Content in this material is for general information only and is not intended to provide specific tax or financial advice or recommendations for any individual. Clients should consult with their qualified tax and financial advisors as appropriate.
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