Opening an Educational 529 Plan
529 plans were created in 1996 and are named after section 529 of the Internal Revenue code. They are operated by state or educational institutions and provide tax advantages when the funds are used to pay for college or other post-secondary training. Earnings are not subject to federal or state tax. Up to $14,000 per year can be contributed per 529 plan.
I started researching these 529 plans initially as a means to reduce taxes.
Unfortunately, what I discovered was that a 529 plan was not going to help me for any immediate federal or state tax deductions. From a federal tax standpoint, while contributions to a 529 plan are not deductible, earnings are not subject to federal tax upon withdrawal when used for the qualified education expenses.
There are over 30 states that do allow tax deductions from contributions, but Minnesota is not one of them.
Another thing to remember when opening a 529 plan is that you need to choose a beneficiary. This typically is the name of your child who will use the money to pay for college educational expenses. I don’t have any kids yet so instead opened a 529 plan in my own name. I’ll be able to start contributing to it now and be able to change it to a child a few years down the line.
Despite not being able to get any tax deduction benefit, getting 18+ years of tax free growth will be worth it.
I compared a bunch of plans and ended up going with Nevada’s plan, which is through Vanguard. I went with them because they had one of the least expensive management fees, good selection of mutual funds to invest in, and I’m becoming eligible for my company’s 401k in July and that is through Vanguard as well. Won’t hurt to consolidate things as much as possible.
Vanguard’s 529 plan requires a minimum initial contribution of $3,000. I invested that and have chosen (for now) to contribute an additional $75 per month. I’ll increase this amount in the future.
I picked the Vanguard Aggressive Growth Portfolio with a low 0.17% expense ratio. This fund invests 60% in the Vanguard Institutional Total Stock Market Index Fund and 40% in the Vanguard Total International Stock Index Fund. It’s very easy to switch the fund that the 529 plan is invested in. Nearing when the fund will likely be used, it would make sense to transition to more conservative investments.
$3000 invested now compounding at a conservative 5% interest rate would amount to $8138 in 20 years. With the $75/month contribution, the total amount in 20 years becomes just over $39,000. Not too shabby, but still not nearly enough to pay for college even at today’s prices, let alone after 20 years of inflation! I’ll definitely be increasing the annual contributions in the future. If I were to do 20 years of $14,000 per year, then the investment would rise to nearly $490,000 ($283,000 in contributions and the rest in compounding growth).
Does anyone else contribute into an educational 529 plan? If you have kids and are hoping to help with college expenses, I think it makes a lot of sense. Plus, you may live in one of the lucky states that allows tax deductions!
Thanks for sharing your experiences. These sound like our RESP accounts in Canada, which are a wonderful for college savings. That said, it’s even better you can open this account and then change the beneficiary once you have a kid. Very interesting!
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Thanks, Jay. Yep, does sound like RESP accounts. Being able to switch the beneficiary is a cool advantage to these accounts!
I feel like 529 accounts are the gold standard here in the USA. They have tons of uses but I do worry about the limitations of what those funds can be used for. I had a few friends in college get their hands slapped when trying to get money out for their semesters when it was clearly an educational use but it was seen as a non-educational use. Have to make sure to look at what they can be used for before investing in them.
Thanks, Dividend Reaper. It will be a number of years (probably at least 20 years) before the money will be used anyway. I’ll be sure to keep these issues in mind when I finally will start withdrawing from them.
I also think it hurts kids applying for scholarship, tuition assistance etc. http://www.savingforcollege.com/intro_to_529s/does-a-529-plan-affect-financial-aid.php. It seems your better off just putting it into a cash acct in you rname and let it ride, then use for college later.
Thanks for the comment, Nick. I’ll be sure to keep that in mind. However, according to that site, “assets in accounts owned by a dependent student or one of their parents are considered parental assets on the FAFSA.” “When a school calculates the student’s Expected Family Contribution (EFC), only a maximum of 5.64% of parental assets are counted.”
It looks to me like the financial impact would be the same no matter where the funds are being kept. The impact may be more given that the 529 plan will hopefully grow faster than an equivalent amount set aside in a taxable account. If that’s what you’re getting at, then, yes, the 529 would be larger and therefore the 5.64% of parental assets counted would also be larger and therefore lead to a higher EFC.
In the long-run, we’ll be ahead of the game by investing the money anywhere, be it in a 529, taxable account, or even just CDs…every little bit helps.
Talk about being proactive. I think it’s great that you are already thinking about an investment plan for a child that you do not yet have. I just posted a quarterly update for baby DivHut’s dividend portfolio. No 529, just a regular taxable custodial account. I wanted to create a “no strings attached” portfolio that can be utilized any way he wants. I really question the long term value of a college degree especially in two decades time.
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Great comment, DivHut. I’ll probably open a future child a custodial account as well to help him or her understand investing and the power of compounding. In fact, the account I currently have actually started off as a custodial account that my parents started for me when I was 13 years old. I took official control of it when I turned 18. I then drained the investments completely to help pay for medical school. (My accounts were starting my scratch in 2011).
Good point about the long term value of a college degree in two decades. Worse comes to worse, I’ll just be able to remove the money and pay the 10% penalty if it is not used for post-secondary education.
Great post, thanks for sharing. I’ve got a 529 for my kids as well, though it is severely underfunded!! haha. My oldest is 2 only, so we’ve got some time I hope. Thanks again,
Passive Income Dude
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Thanks, Dan. Do you have a 529 for each kid? I’m wondering if I will be doing that in the future or just changing the account beneficiary when (if) that time comes. If your oldest is 2 years old, you have plenty of time and are also WAY ahead of the curve when it comes to planning ahead for future educational expenses.
I like the idea of the 529 plan and will probably end up getting on down the road when I have my own children. But you have to remember that it is a state program. That being said, every state has their own set of rules on how they want it to be run or what rules apply. Some/ most states also need a holding period before money can be withdrawn. Usually the money has to be in the account for at least a year before it can be taken out and used for school expenses. Either way, as long as you know the rules ahead of time, it can be a very useful tool. Thanks for sharing.
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Thanks, Dividend Daze. Yep, I didn’t know when I started researching them that each state has its own (sometimes more than one) 529 plan. Each has different maximum amounts that can be contributed. And some states have better tax benefits than others. Fees are also different between the various state plans.
A nice thing about all these plans is that they do not have to be used for post-secondary in the state that the plan in managed in. My future kids will not need to go to school in Nevada.
Thanks for the comment!