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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

529 college savings plans even better in 2024

As college costs continue to climb and student loan debt surges, it is more important than ever to begin saving early for higher education. Perhaps the best tool in preparing financially for college is a tax-favored account called a 529 college savings plan. Yet according to a recent survey, less than a third of Americans actively saving for a child’s education are aware of their existence.

Although they’ve been around for a while, several recent developments make 529 plans even more attractive, and any parent or grandparent trying to prepare should know about them.

Technically called “qualified tuition plans”, 529s are sponsored by states to promote saving and investment for higher education and offer significant tax incentives. They are similar to Roth IRAs, funded by after-tax contributions and distributed federally tax free to cover qualified educational expenses. And new rules provide even more flexibility and alternatives if the child does not go to college or doesn’t use all the money.

State-sponsored college savings plans began in 1986 with the Michigan Education Trust. The MET was a prepaid tuition plan that allowed parents to deposit a defined sum in advance that guaranteed tuition at any of the state’s public institutions. A few other states including Florida and Wyoming also established prepaid programs.

Congress codified a tax preference in 1996 with legislation creating Section 529 of the Internal Revenue Code covering prepaid tuition but also establishing “education savings plans” that allow parents or other individuals to contribute on behalf of a future student to defray tuition at any eligible college in the US. Within 4 years, 30 states created versions of 529 saving plans.

The original iteration of Section 529 merely deferred taxation on earnings until the funds were withdrawn, more like a traditional IRA account. However, in 2001 Congress fully exempted all earnings from federal taxation if the funds are withdrawn for qualified higher education expenses. Today, 49 states and the District of Columbia offer 529 savings plans.

Anyone can open a 529 account as the owner. The account is dedicated to the education of one individual called the beneficiary who can be any age and even be the owner. Each state sets its own lifetime contribution limit currently ranging from $235,000 to $550,000 not including earnings. Contributions up to $18,000 in 2024 are exempt from gift tax reporting, while amounts over the annual limit reduce the lifetime estate and gift tax exemption (currently $13.6 million).  Anyone or any number of people can contribute to a 529 and need not be related.

Funds are invested in defined portfolios approved by each state which generally fall into two categories. Static plans are simple asset allocation portfolios ranging from conservative to aggressive. Age-based plans begin with a more aggressive allocation and gradually reduce risk as college enrollment approaches. Portfolios can be changed or redirected twice per year.

The account owner can also change beneficiaries if the student does not use any or all the funds. The new beneficiary can be any family member very broadly defined including other kids, parents, grandparents, in-laws, even foster children, and accounts never expire.

Qualified educational expenses are also expansive including tuition, room and board, books, fees, and equipment. And recent sweeteners to Section 529 allow the funds to be used for K-12 education (up to $10,000 per year), to retire up to $10,000 in student loans, and even cover many career training programs including registered apprenticeships.

Another new wrinkle is the ability to convert up to $35,000 of 529 funds into a Roth IRA for the named beneficiary once the account has been open for 15 years. And in the extreme, say 30 years from now, withdrawing the money outright triggers a 10% penalty plus taxes on the growth, not exactly the end of the world.

While any state’s plan is better than no plan, some are clearly superior. The first factor to consider is cost: expenses, fees, and sales charges eat into long-term returns. A 2023 report from Savingforcollege.com finds that the most expensive state plan is nearly 10 times as expensive as the cheapest. Research has also consistently demonstrated that expensive plans do not produce superior results; in fact, on average, the less costly plans generate the best investment returns over time.

Two thirds of 529 plans are set up directly by the account holder, with the remainder being “advisor-sold” plans opened through an intermediary like a broker or investment advisor. Broker-sold plans typically have higher costs including sales charges to compensate the broker. Plans opened through a Registered Investment Advisor do not assess sales charges and have lower costs, but the advisor may charge you an asset-based investment management fee if you want them to manage the account.

Another factor to consider is potential state tax breaks, as 30 states offer a deduction for contributions. Tennessee has no income tax and hence no tax break, but if grandparents in a high tax state want to pony up, it may be worth considering their state’s 529 option.

There are resources available to help cull the herd. Morningstar.com, Collegesavings.org, and Savingforcollege.com offer tools and ratings to evaluate the myriad choices, and you can ask your financial professional for advice. Just remember that expenses matter, so compare plans.

With college costs doubling over the past 20 years and nearly 1.7 trillion in student loans outstanding, families should consider this powerful tool and get started early.

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