Why You Need to Open a 529 College Savings Plan

Unless you’ve been hiding under a rock, you’ve likely heard of or experienced first-hand the meteoric rise in the cost of higher education and the related “student debt crisis” that looms as college-bound students have taken on a historic amount of debt.

What’s more, the cost of some of the nation’s most selective institutions are rising even faster than those that are more accessible.  According to USA Today, the nation’s top 50 public universities (as ranked by the US News and World Report) are raising their tuition by an average of  3.6%  annually–about a full 2% above the inflation rate (as has apparently been the case for decades).  Want to attend Yale or Lehigh? Good luck paying the approximately $50k per year sticker.  Want to attend any old private college? Well, that will set you back $33k (and the situation is not that much better if you are in a state that doesn’t have a name-brand public university and you want to attend a top public out-of-state, in which case you will end up paying almost the same as private tuition).

Whether you blame this phenomenon on universities for engaging in the educational equivalent of a nuclear arms race for amenities, sports teams and star faculty, the government for backstopping and/or helping to provide cheap debt via generous forbearance and income-based loan repayment policies, or stagnating wages among the middle class, the simple fact is that picking yourself up by the bootstraps and sending yourself to a college rife with networking opportunities is not as realistic for most of us today as it was a couple of generations ago.  (I would always chuckle when some well-intentioned older person reminisced about how they paid their way through college or suggested that someone in my position could realistically do the same).

So, we are faced with the question of how to finance a college degree that may cost upwards of $500k in 18 years if current trends continue.

As with any form of problem solving, there is always more than one way to skin the proverbial cat.  You could take the conservative approach and sock money away in a savings account in an FDIC-insured institution, all but assuring the money will be there in 18 years (albeit having earned virtually no interest).

Another riskier, but potentially more lucrative, approach would be to open a standard, taxable brokerage account (e.g., at Fidelity or Vanguard) and invest in a diversified portfolio of assets, including stocks, bonds, ETFs and/or mutual funds that is appropriate for an 18-year time horizon.  Sure, assuming you only invested in the S&P 500 or DJIA, you might achieve the much-publicized average 7% annual return everyone talks about, but you also might not and, most importantly, any return you do achieve will be taxed at the then-applicable tax rate.

You might even think of opening a custodial account under the Uniform Transfers to Minors/Uniform Gifts to Minors Acts (i.e., a UTMA/UGMA account), effectively transferring the tax burden from any earnings to your child (and allowing them to use your proceeds for pretty much anything they desire after they reach the age of maturity).

But one approach–which to me seems like a no-brainer—is to use a tax-advantaged 529 college savings plan.

529 College Savings Plans:  The Basics

So, what exactly are  529 college savings plans?  529 college savings plans are tax-advantaged savings plans authorized by Section 529 of the Internal Revenue Code that allow college savers/account holders to establish investment accounts for students/beneficiaries in order to pay for eligible college expenses.  “Eligible college expenses” generally include tuition, fees, room and board, books and supplies at any eligible (i.e., recognized by the U.S. Dept. of Education) post-secondary institution, including colleges, universities, graduate and/or technical schools.

529 plans are typically sponsored and administered by the states and often managed by a third-party investment manager, such as Vanguard or Fidelity. Currently, each state provides a form of college savings plan except for the state of Washington, which only offers a pre-paid tuition plan–another type of plan authorized under Section 529, which is offered by only a few states, that allows savers to pre-pay and, as a result, lock-in tuition rates years in advance of attendance.

529 college savings plans are extremely flexible in that they can be opened by anyone—it doesn’t have to be a relative of the intended beneficiary–who is a U.S. citizen or resident alien for the benefit of anyone who is a U.S. Citizen or resident alien and account openers can generally contribute up to $300,000 to $400,000 per beneficiary.  Furthermore, most states offer at least one 529 college savings plan that is not subject to residency requirements (meaning you can contribute to it even if you are not a resident in the state and/or attend a college out of state).  However, if you participate in another state’s 529 plan, you may miss out on certain additional tax advantages offered by your state’s plan.

Tax Treatment – Where’s the Beef?

The primary benefit of 529 college savings plans is their tax treatment.  Under such plans, earnings are not subject to federal and, in most cases, state taxes, as long as you use the proceeds for eligible college expenses of the designated beneficiary.  Additionally, many states offer their own income tax or other benefits, such as matching grants or the ability to deduct contributions for the current tax year (in New York, for example, account holders can deduct up to $5,000 per year if they file separately and $10,000 for couples filing jointly).

So, for the sake of argument, let’s say you are married, filing jointly today in the state of New York, plan on contributing up to the maximum deductible amount ($10,000), have a household income of $150,000 and an effective state tax rate of 5.5%.  Taking the 529 contribution in isolation (i.e., not considering any other tax effects), you would reduce your taxable income for that tax year by $550.  Not a fortune, but savings add up over 10, 15, 20 years.

But earnings are where the real benefit comes in:  Let’s say your first child was just born and you intend for her to attend college in 18 years (when you will start drawing down on the 529 plan).  Using the typical 7% as the benchmark for annualized stock market returns (and I note for the sake of my readers that these sorts of returns are NOT guaranteed), this $10,000 will be worth roughly $33,800 due to the power of compounding by the time your daughter starts college in 18 years.  That’s $23,800 in earnings.  Now, further assuming you have an effective federal tax rate of 20% and are filing jointly, if you withdraw the $33,800 in year 1 of your daughter’s college education, the federal tax savings of contributing to the 529 plan in isolation would be 20% x $23,800 or $4,760.  Assuming the earnings are also exempt from state taxes at the 5.5% effective rate, you are now talking a total savings of over $6,000, and that’s only one year’s worth of contributions!

Other Benefits

One of the biggest benefits of a 529 college savings plan (as opposed to contributing to a UTMA/UGMA custodial account) is that you, as the account owner, not your child, maintain control over the assets in the account over the life of the plan.  This has a few important implications:

  • You can generally, at any point in time, change the beneficiary of the plan to an eligible “family member” (which typically includes anyone in the original beneficiary’s nuclear family and first cousins, but is plan-specific). You can even make yourself the beneficiary (and making yourself the beneficiary BEFORE your child is born is a great way to start contributing to a plan before your child is born).  This way, if your kid ends up not wanting to use the money you painstakingly set aside for its intended purpose (school), you can transfer it to someone who will.
  • Since the funds are yours, you can withdraw them for non-educational purposes if need be, though, any such amount withdrawn will be subject to a 10% tax on earnings (in addition to any state and federal taxes).
  • For the purpose of determining financial aid, assets in a 529 plan will be considered assets of the parent, rather than the child, which are generally given less weight in determining the amount a family is expected to pay for a child’s education in determining financial aid.

Additionally, while contributions to a 529 college savings plan are subject to the federal annual gift tax exclusion of $14,000 per person (meaning you can gift up to $14,000 tax free in a given year without that amount being subject to the federal gift tax), 529 plan contributors have the additional benefit of being able to make a lump sum payment of $70,000 in any given year in lieu of making $14,000 gifts in each of the next 5 years.  The benefit here is that the beneficiary gets to accrue earnings on the full $70,000 from day 1.  (Note that the gift tax is really only a factor for individuals/married couples with estates greater than $5.45/11 million, but this is something to discuss with your financial and/or tax advisor).

What Can I Invest In?

Generally, each plan allows contributions to be invested a variety of mutual funds and exchange-traded fund portfolios and are very similar to those you might see offered by your employer’s 401(k) plan.

If, for example, you are a participant in New York State’s direct 529 college savings plan, you might have the option to invest in the “Vanguard Growth Index Fund” (called the “Growth Stock Index Portfolio” on the website), which is a broadly diversified index comprised of stocks of large U.S.-based growth companies (and as of the date of this article, include names like Apple, Amazon and Home Depot).

A participant in Wisconsin’s Edvest college savings plan might instead choose to invest contributions in the “Bond Index Portfolio” (i.e., the “TIAA-CREF Bond Index Fund”), which is comprised of fixed income securities, and seeks to provide steady periodic income (as opposed to returns from “growth” in the price of the underlying security).

Many college savings plans also offer age-based investment options, which is ideal if you want to “set and forget” your investment preferences so you don’t have to log in periodically to rebalance your portfolio.  If you participate in an employer-sponsored 401k plan, the age-based concept here is similar:  You choose the appropriate investment option which automatically, over time as the beneficiary reaches college age, moves your savings from more aggressive (i.e., risky) investments that can yield higher returns, usually stocks, to more conservative investments, mostly bonds and cash/cash equivalents, which typically produce relatively low, but reliable returns.  If you choose the age-based approach, certain plans might provide several additional options further tailored to your risk tolerance. An aggressive age-based option will generally start out more heavily invested in stocks and transition to all bonds/cash more slowly than a moderate, or conservative option.

Regardless of which approach you choose, note that under current federal tax laws, you are only allowed to change investment options twice in any calendar, so make sure you’ve thought out your allocations!

Also, surprised by the absence of the ability to invest in individual stocks and bonds?  Don’t be.  The goal of these plans is to encourage long term saving and investment for college expenses, not to (potentially) incentivize speculation.

What’s the Catch?

Notwithstanding the advantages of 529 college savings plans, there are a few disadvantages of which one should be mindful.

  • First, as mentioned above, if funds are withdrawn for any reason other than to provide for eligible college expenses, any earnings are subject to a 10% penalty (on top of federal and state income taxes), unless the reason for not using plan assets is that the beneficiary obtained a scholarship (including from a U.S. service academy).
  • Additionally, as with any other investment, the privilege of investing isn’t free: there are fees to pay which, depending on the plan, can include enrollment fees, administrative and maintenance fees and asset management fees which can cut into your initial investment and earnings. Without going into exhaustive detail over the fee structure of 529 plans, it should be noted that certain states offer “direct” savings plans which are offered directly by the state’s plan sponsor/manager instead of through a broker.  Such “direct” plans are generally cheaper that those via the brokers since they do not involve sales commissions or load fees.
  • Other things to look out for include any fees or taxes (including recapture of tax deductions) that may be assessed if you want to “rollover”, or switch over, to another state’s 529 college savings plan and, if you have a particularly large estate, be mindful that any contributions above the annual federal gift tax exclusion  limit could be subject to the federal gift tax.


For those who have (or hope to have) college-bound children, 529 college savings plans provide a great way to get a head start on paying for college expenses.  This is especially the case given the dramatic rise in college tuition over the past few decades.

That said, please be sure to consult your financial and/or tax advisor(s) before contributing to any 529 plan to make sure you understand the implications of making an investment and that it makes sense in light of your financial situation.

For DMs regarding this post, please use the below form:


Leave a Reply

Your email address will not be published. Required fields are marked *