Saving for Education 101: The 529 Plan

Jake VanKersen: Sitting down and figuring out how to pay for college one day in the distant but fast-approaching future can feel daunting. One often used option is a 529 savings plan. What is it? How does it work? And what are the strengths and limitations?

Madeline Hume: 529s are a strange beast in the investing world. Basically, they are tax-advantaged investment accounts that grew out of prepaid tuition plans, which help families save for college by buying tuition units that they could then use for a future date. But these prepaid plans were limited to specific universities or school systems. 529s eliminate that inflexibility by allowing investors to save and invest that money in either stocks, bonds, or a combination of both in order to appreciate their savings over time to help fight tuition inflation.

VanKersen: What are the tax benefits you mentioned that come with using a 529 plan?

Hume: There are two potential tax benefits that an investor might enjoy. The first applies to all 529 investors regardless of the state that they live in or the 529 plan they contribute to, and that's an exemption from federal investment taxes. These taxes come in the form of capital gains and ordinary income taxes, and the exemption means that investors can contribute their aftertax earnings into an account, watch it grow over time, and then withdraw those monies without having to pay any taxes. This account can be used on any qualified education expenses, which have been expanding rapidly in recent years.

The other potential benefit is a state income tax deduction. Not every state offers this, but some states allow you to deduct your contributions from your income, reducing your overall tax burden. And these tax benefits can be pretty meaningful when compounded over time.

VanKersen: When you say "educational expenses," what exactly does that cover?

Hume: It's a good question because the definition has changed pretty meaningfully in the past couple of years. So, in the not too distant past, it used to be the case that 529 withdrawals could only be used on college tuition and associated expenses. But with many people not pursuing the traditional four-year education, Congress has expanded the flexibility of these plans to include not only apprenticeships and the trades but also student loans and private K-12 education. So, there's a lot of different ways that investors can withdraw their money and still receive those tax benefits.

VanKersen: Yeah, that covers a lot. Still, what happens if, after everything is said and done, somebody's plan doesn't include a college or university or anything else that you've mentioned?

Hume: There might be investment merit to the idea of keeping those assets in a 529 account for a rainy day. Many people are considering midcareer pivots or continuing education in order to prepare themselves for the world we live in, you know, maybe during a pandemic or something like that. However, there are circumstances where an individual isn't interested in pursuing continuing education. And in those circumstances, it might make sense to transfer the assets to another beneficiary. If that beneficiary is in your immediate family, there are actually no tax consequences to transferring those monies over, and they can also apply to sibling student loans and cover existing balances on that front.

VanKersen: Now, if somebody has heard all of this and they are ready to go ahead and contribute to a 529, how do they go about doing it?

Hume: Morningstar analysts have tried to synthesize the entire universe of more than 85 529 plans into their rating system. So, today, we rate 61 of the largest 529 plans on a scale ranging from Gold all the way down to Negative. Gold, Silver, and Bronze are our recommended ratings, and investors who are looking at these plans can feel confident that they've made the right choice. Neutral and Negative plans may also make sense for individual investors, but they should look at any potential tax benefits to see if they offset some of the detractions of these plans, which may come in the form of higher investment fees or lower-quality investment options.

VanKersen: Now, one thing to know is that an investor isn't limited to their own state, right? Like, if they find a better plan somewhere else, they can pursue that one?

Hume: One common misconception that many investors have is that they are restricted to their own state's plan, but that's not the case. And in fact, about 50% of the country lives in a state that either doesn't offer income tax benefits for investing in a 529 plan or those income tax benefits apply to any 529 plan and not just their home state's. So, investors can really consider the entire menu of 529 plans available to them, but there may be those state-specific tax benefits that could make the difference. And in fact, Morningstar Research has shown that about 24 of the 35 plans that do offer these in-state benefits actually pay for the cost of the investment management of their direct-sold plans for more than 10 years. That's basically 10 years of free investment management, and that can be hard to pass up.

VanKersen: I've heard that there's no default option in 529 plans like there is in a 401(k), for instance. Once investors have picked a 529, how can they decide which investments to choose?

Hume: 529 plans offer a wide swath of investment options, and it may be overwhelming to look at. The most common investment options that investors will choose are age-based options. These are allocation investments that shift from stocks to bonds over time, gradually getting more conservative as a beneficiary approaches an enrollment date or a particular age. But these options are often managed to an 18-year time horizon and, since we've been discussing the flexibility of 529 plans, aren't always the right fit for somebody who has a timeline that isn't in line with that 18-year time horizon that most plans are managing towards. For them, static options might be a better choice. These are investments that don't change over time and typically take the form of something like an S&P 500 fund or a 60/40 balanced fund or even a money market option. For investors who are trying to meet a nontraditional investment horizon or don't know when they're going to draw down on their savings might have to look at these in more detail.

VanKersen: Thanks, Madeline, for letting us copy your homework when it comes to finding out how to pay for college.