529 College Savings Plans | An Under Used Tax Protected Investment

by RJ

in Investing

What do you think of, when you hear the word, “Tax efficient investing.”

If the words 401(k) and IRA popped up, great. These two accounts are by far the best and most common way to invest tax efficiently. However, they are not the only way. One account that gets hidden underneath the table of investment options is the 529 College Savings Plan.

The purpose of this post is to describe what exactly a 529 College Savings Plan is, and more importantly, to see if you have a need for this type of investment account in your personal financial plan.

Before I get into the details, it’s important to know that there are two types of 529 plans. This post discusses 529 College Savings Plans. The other type of 529 plan is known as the 529 Prepaid Tuition Plan. Prepaid Tuition Plans do serve a purpose, but that is out of the scope of this post.

What are College 529 Savings Plans?

A 529 College Savings Plan allows you to contribute and invest money into an individual account, designated for postsecondary education (education after high school) expenses. The contributions and earnings are allowed to grow tax deferred and be withdrawn tax free, if used for qualified educational expenses.

Qualified education expenses include:

  • Tuition
  • Room and Board (full time students only)
  • Fees
  • Books, Supplies, and Equipment (Even necessary computers and software)

The investment options of a 529 College Savings Plan is similar to that of a 401(k). The main difference is that each individual state administers their own 529 College Savings Plan. Each state chooses their own investment provider and works with that provider to offer a variety of investment choices. Just like an individual companies 401(k) plans, each state’s plan is different from the next.

The good news for you is that you can invest in any state’s plan, even if you’re not a resident of that state.

Last, there is no Federal Tax deduction for contributions to a 529 College Savings Plan, unlike you get with Traditional IRA contributions. However, some states do allow their residents to receive a state income tax deduction, as long as they invest in their state’s 529 plan.

The #1 Reason to Start a 529 College Savings Plan

The #1 reason most start a 529 plan is to fund their own children’s college tuition and expenses. A typical investor into a 529 College Savings Plan is a parent who just had a child.

The parents start a 529 College Savings Plan and list their infant child as the beneficiary. Eighteen years later, hopefully after many months of dollar cost averaging a few hundred dollars per month into their account, they can afford to pay for their child’s college tuition.

Additional Uses for 529 Plans

Saving for your own children’s education, is a great reason to start a 529 plan, but it’s not the only one. The IRS has given owners of a 529 College Savings Plan a lot of flexibility, as to how the funds are used.

As the owner of a 529 College Savings Plan, you have total control over the investments, and more importantly total control of the beneficiary. Unlike other college saving options such as the UTMA, the beneficiary has no right to the money.

Although, you have to keep in mind gift tax consequences, you can change who the beneficiary is at any point in time, to another member of the family with no income tax consequences. Plus, the beneficiary can be you because there are no age restrictions on who can use the fund. .

Therefore, even if you don’t have kids yet, you can start a 529 College Savings Plan for yourself, and name your child as beneficiary once they are born. If you have maxed out your retirement savings through 401(k) s and IRAs, this is one of the last remaining tax-free investments available. Even better, by starting earlier, you save less for your future children’s education because compound interest gets a few more years to work its magic.

Another misconception about College 529 Savings Plan is the understanding of what qualifies as postsecondary education. Have you thought about taking a cooking or art class at a local community college? Great! Cooking and art classes, including the supplies necessary for the class, are a qualified expense, as long as they are at an eligible institution.

Speaking of eligible institutions, did you know that there are many International schools that are eligible institutions? You can actually use a College 529 Savings Plan to take a cooking class in Italy or an art class in France.

Have you thought about going back to graduate school or taking other types of career advancement courses? As long as they are given at a qualified education institution, they are qualified education expenses.

Is a 529 College Savings Plan Right for You?

Remember, that you can always borrow money for education expenses, but never for retirement. Therefore, if you haven’t gotten your retirement savings started, hold off on starting a 529 Plan.

If you’re contributing heavily to your 401(k) and IRA, a 529 College Savings Plan is another investment vehicle to maximize the after tax return on your investment. Which after all is said and done, the goal of investing.

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{ 5 comments… read them below or add one }

Jacob @ My Personal Finance JourneyNo Gravatar January 16, 2011 at 7:51 pm

Nice post! So quick question here – do you know what happens if you save up money in a 529, and then your child gets a full ride to college. Would you just have to take the distribution as a taxable event? What are the restrictions on how it can be used?


RJNo Gravatar January 17, 2011 at 10:23 am

@Jacob – Great question.

If you’re child gets a full ride scholarship, you’re eligible to take a penalty free withdrawal for up to the amount of the scholarship. Although, you do pay federal and state income tax on the earnings portion of the withdrawal.

Also, keep in mind that even if your child does get a full ride there are many expenses not paid for by the scholarship but still qualify for a 529 plan. For example, a new computer, software, textbooks are all qualified expenses under a 529 plan that are not necessarily covered by a scholarship.

Hope that helps.


Jacob @ My Personal Finance JourneyNo Gravatar January 17, 2011 at 7:42 pm

That’s awesome information to know! Thanks RJ!


RJNo Gravatar January 18, 2011 at 10:45 am

No problem Jacob.


rickyNo Gravatar February 7, 2011 at 9:13 am

Great info! Cheers, very helpful


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