The Benefits and Drawbacks of 529 Plans

With cumulative student loans having hit the $1.5 trillion mark, you would be doing your children a huge favor if you were able to contribute to their college education. One of the most popular ways of doing so is with a 529 plan. However, before you rush to open a 529 account, here are a few things you should know about choosing one to save for your children’s college education.

The Purpose of a 529 Plan

A 529 plan allows you to put money each year into a designated account on behalf of a beneficiary. This amount can be withdrawn tax-free down the line if used for qualified higher education expenses. Think of it as the government granting you tax advantages in return for saving for a beneficiary’s future college education. Moreover, 2018 changes mean that a 529 plan can also be used for K-12 public, private, and religious school tuition.

Contributions and Deductions

While most states have very high lifetime contribution limits for a 529 plan (usually $300,000 or more), many people cap their annual contributions at $15,000 per year to avoid incurring federal gift taxes. Another option is a lump sum contribution of $75,000 for five years’ worth. Also, anyone, not just the trustee of the account, can make a contribution into a 529 account on behalf of the beneficiary.

Unlike 401(k) plans, there are no federal tax deductions at the point of contribution for 529 plans. However, depending on the state, there may be state level tax deductions. In Pennsylvania, a person can receive up to $14,000 in tax deductions ($28,000 for married couples). The amount in a 529 plan can also be withdrawn tax-free as long as it’s used for qualified education expenses. Unqualified deductions will be subject to the usual state and federal taxes, plus an additional 10% penalty fee. For a list of qualified education expenses, you can have a look at this IRS page.

The Two Types of 529 Plans

Education Savings Plans

This is the most common type of 529 plan and is available in every state. It’s an investment account, meaning that money you place in this account will be invested in a range of portfolio options.

You have several options when it comes to the type of investments your 529 account is invested in, although they are typically composed of mutual and exchange-traded funds (ETFs). Depending on when the beneficiary is due to begin college, some plans may also offer you portfolios geared toward maximizing returns by said date (age-based options).

In Pennsylvania, this type of plan is called the Pennsylvania 529 Investment Plan. The Vanguard Group manages the 529 investments and there are 16 different options you can choose from.

Prepaid Tuition Plans

This is a rarer form of a 529 plan that is currently only available in a handful of states, including Pennsylvania. In this type of plan, you can buy credits or units at participating institutions (at current prices) for use at a future date. While the money deposited into such a plan is also invested by the plan administrator, the ‘withdrawal’ of the account is in the form of college units or credits.

Some states may not guarantee the plan, meaning that adverse market conditions could potentially lead to the plan being unable to cover the supposedly paid-for credits. However, in the case of Pennsylvania, the account is invested by the Pennsylvania Treasury Department and is also guaranteed by the state.