As parents envision the future, many hope their children will one day pursue higher education. It can be a rite of passage, the continuation of a family tradition, and an opportunity to become more independent. Importantly, a college degree also translates into material financial benefit through higher quality jobs, higher earnings, and higher rates of home ownership. Yet college is also extraordinarily expensive, and historically, the cost has grown faster than broader inflation.
This leads to a common concern for many parents: how to pay these increasingly high costs? Enter the 529 plan, a specialized investment account designed specifically to incentivize saving for future education expenses. There are two types of 529 plans, pre-paid tuition plans and education savings accounts, with the latter being far more common. This article focuses on education savings accounts, which we’ll refer to more generally as “529.”
Who Should Use a 529?
529 plans offer opportunities for parents, grandparents, and other friends and family to contribute toward a child’s education. For parents, the accounts offer a tax-efficient way to save for college, grad school, or other education expenses. Even while tuition bills seem far off in the future, this powerful tool can help parents establish the habit of saving early on and ease some of the financial and psychological stress that can arise as college enrollment approaches.
For grandparents and other loved ones, 529s offer a way to help shoulder the cost of college in a tax-efficient manner. These accounts can be good places to make gifts for birthdays, holidays, or special occasions, as well as a way to share values around education. In certain circumstances, 529s can also be a useful estate planning tool, offering a way to move additional assets outside a family’s taxable estate.
What Are the Benefits of a 529?
The primary benefit of a 529 plan is tax-free investment growth. As long as withdrawals are used for qualified education expenses, investment earnings are tax-free at both the federal and state levels. This can be very powerful, especially for 529s where the investments have a long time to grow. Beyond tax-free withdrawals, some states offer additional tax incentives for contributing to a 529 plan, such as an income tax deduction or a tax credit. California, unfortunately, is not one of those states.
Expenses that qualify for tax-free withdrawals include many costs one would expect, such as tuition, room and board, books and supplies, and mandatory fees. They also include certain other expenses, such as a new computer and rent for off-campus housing. Newer federal legislation has further expanded the definition of “qualified” to include K-12 private school tuition as well as student loan repayment. These newer benefits are limited in certain ways, and some states (again, including California) do not currently recognize them as “qualified” for state tax purposes.
Lastly, another benefit is that the owner of the 529 plan retains control of the funds, even though there is a designated beneficiary for each account. This is helpful when there are excess funds in the account, or when life changes and funds are needed for something other than tuition payments.
What if I Don’t Use All the Money?
Sometimes money can be left over in a 529. The beneficiary might have gone to a less expensive school than expected, they may have received a scholarship, or they may have decided not to pursue higher education at all. Whatever the reason, there are several options for excess money in a 529 plan.
The simplest option is to change the beneficiary to a relative of the original beneficiary, which is allowed under 529 plan rules. “Relative” is defined quite broadly, ranging from siblings to aunts and uncles, cousins, step-relations, in-laws, and more. If the new beneficiary has qualified expenses, the 529 can be used to pay for them tax-free. Looking further into the future, unused 529 funds can also be used to fund intergenerational family education. For example, a child’s unused 529 funds could eventually be used for their child’s education and can benefit substantially from tax-free growth during those additional years.
Recent legislation also allows 529 dollars to be used to fund a Roth IRA for the beneficiary, starting in 2024. This option is new and quite complicated, so it should only be pursued in coordination with your financial advisor and tax professional. That said, it can provide additional flexibility for unused 529 funds.
If all else fails, 529 dollars can always be used to pay for non-qualified expenses – a new car, a trip to the Yucatan, or maybe a celebration at Chez Panisse. The account owner retains full control over the funds; they simply have to pay the taxes and penalties associated with the withdrawal.
How Much Should I Save?
As with any financial planning, saving for college needs to be personalized to your family’s financial circumstances and current cash flow. How many children do you have? Will they attend a public or private college, or maybe a vocational school? How should you balance saving for education with other priorities?
Answering these questions requires intentional planning and an understanding of your financial resources, current and future income, and other priorities that may also require saving. Our team at North Berkeley supports clients in navigating these questions and creating a plan for education savings.
About Sam Wood-Bednarz, CFP®
Sam Wood-Bednarz is a Partner, Senior Advisor, and Director of Financial Planning. He provides clients with a sense of confidence and security in their financial lives.
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