For any parent, college funding is top of mind. With college tuitions rising like crazy (some are over $75,000 now…😳), it puts greater pressure on you to save for college while your kids are young. It’s not easy for most folks to just dish out $75,000/year from their annual cash flow when those college tuition bills come due.
Once you are ready to start saving for college, how should you do it? The most common options are either a 529 plan or a taxable account.
Pros and cons of a 529 plan
A 529 plan is the most common way to save for college. This account is specifically earmarked to pay for qualified educational expenses. The list of qualified educational expenses is long, but the most relevant are tuition and fees (including $10,000/year for K-12), room and board and college supplies (unfortunately, Bud Light doesn’t make the list…).
DOES A 529 plan make sense to save for college?
Pros of a 529 plan
Cons of a 529 plan
Tax-free growth on investment earnings
Ability to transfer funds to a qualifying family member
Some states provide modest tax deductions for contributions
Ability to lump 5 years’ worth of annual gifts into 1 year
Pay income tax & 10% penalty if funds are not used for qualifying expenses
Limited investment choices
The biggest benefit of 529s is the tax-free growth of investment earnings. This can be really powerful if you start saving for your children’s education early, especially if you can afford to lump 5 years’ worth of annual gifts ($15,000 * 5 = $75,000) when your kids are young.
For example, let’s say you contribute $75,000 to a 529 plan when your child is 5 years old. Assuming no other contributions and 6% investment growth, the 529 plan will be worth roughly $150,000 when your child is 18. If you use the 529 plan for qualifying expenses, it means the $150,000 - $75,000 = $75,000 investment growth is tax-free. If we assume a 20% federal capital gains tax rate and 5% state capital gains tax rate, it means you saved $75,000 * 25% = $18,750 of tax that would be due in 13 years.
But what if your child doesn’t go to college? Or is a killer baseball player and gets a full scholarship? Yes, you could transfer funds to another child, but what if you have leftover funds in a 529 plan?
You would pay income tax and a 10% penalty on the investment growth if you withdraw the funds for non-educational reasons. Using the same example as before, it means the $75,000 of investment growth would be subject to income tax (not capital gains tax!) and a 10% penalty of the $75,000. If we assume your income tax rate is 35%, it means you would pay $26,250 of tax and a $7,500 penalty.
This is the biggest downfall to 529 plans – they lack flexibility. Who knows what the college landscape is going to look like in 10 years? What if colleges gravitate towards virtual learning and lower tuition costs? What if the value of getting a college degree starts to go away in 10 years?
Yes – the tax benefit of 529s can be powerful if used properly, but that benefit is most valuable when you start saving early.
Pros and cons of a taxable account
A taxable account is very simple – it’s an account held in your name, your revocable trust or jointly which can be used for any reason, no matter what. There are no contribution limits, no penalties, no IRS rules dictating what you can and can’t use the account for.
You can open as many accounts as you like and there are no costs to maintain it – you typically just pay trading costs and expenses to the specific funds that you buy.
DOES A TAXABLE account make sense to save for college?
Pros of a taxable account
Cons of a taxable account
Flexibility – you can use it for whatever reason you want
No contribution limits
Broad range of investment options
You pay capital gains tax when you sell funds at a gain
Any income (dividends, interest, etc.) is taxed when received
No tax deductions for contributions
The biggest benefit of a taxable account is the flexibility. Did your son get a full baseball scholarship? No problem – you can now repurpose that account for another goal of yours like financial freedom or a 2nd home. It takes less pressure off specifically using the funds for education.
Building on our previous example, let’s say you put $75,000 into a taxable account when your child was 5 and it grew to $150,000 when he is 18. If you don’t need to use that account to pay for education, you can either keep it invested for your own use (and thus postpone when you pay tax on the $75,000 gain), or you can decide to sell the account and use the $150,000 of cash for a specific purpose.
If you did decide to turn the $150,000 into cash, you would pay (assuming the same capital gains tax as previous), $75,000 * 25% = $18,750 of tax. Now remember – this is a tax you would pay in 13 years. If you think about it in today’s dollars, that $18,750 tax is the equivalent of roughly $13,000 of tax in today’s dollars.
It’s still a good amount of money, but the likelihood is that you would probably keep that account invested and continue to defer all, or a portion, of the capital gains tax until you actually use the account.
What makes sense for you?
The only certainty in financial planning is that things will be uncertain! You can plan all you want, but the reality is that life changes and we are constantly adjusting our path.
You’ve probably heard the saying “don’t put all your eggs in one basket” when it comes to investments, but it also applies to college savings. If you put all of your savings into a 529 plan, you may find yourself paying steep tax and penalties if you don’t use the full amount for qualifying expenses in the future.
I recommend that you diversify how you save for college – don’t put everything into a 529 plan, especially if you are saving for college when your kids are older. The tax benefits of a 529 plan diminish quickly when you reduce the amount of time that the earnings can grow tax-free.
If you can start saving for college when your kids are young (<10 years old), then I typically recommend starting with a target goal of ~50% of college expenses saved up in a 529 plan. If you plan on paying $200,000 over 4 years, it means have a loose target of $100,000 saved up in a 529 plan by the time they go to college. You can still benefit from the tax-free growth, but you also are giving yourself flexibility if you find your kids not using the funds.
There are many other variables that go into this (investment market cycle, state tax deductions, etc.) that is too in the weeds to review here. The overall message is that building flexibility into your financial plan allows you to better change direction when your life changes in the future.
- Before you start saving for education, ask yourself these 3 questions to help you develop a college funding plan. I find that parents often put college savings on auto pilot, but it should be something that is carefully reviewed each year. Perhaps a meaningful family trip to Europe would be a better use of your money than 1 year of college savings.
- Diversify how you save for college. Don’t let taxes drive your decisions. I’d argue that flexibility can be equally, or even more beneficial, than tax savings.
- Each state has a 529 plan and you want to be sure to evaluate your state’s plan, as well as any tax deductions. If your state offers a tax deduction, but the plan contains high costs and poor investment options, then you may be better off using a different state’s plan.
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