One of the most common questions we hear from clients is how best to save for their child or family member’s future education expenses. The 529 college savings plan is one of the most common ways to save for these expenses, but is it the right choice for you? We’ll explore that question and additional considerations in preparing for the rising cost of education.
Planning and saving for a college education is a primary concern for many of our clients who are raising their families. According to 2022 survey data, “63 percent of parents are confident that a college education will allow their children to get a good job, and 60 percent believe it is worth the investment”. But when it comes to paying for a traditional four-year college education, only 36 percent of parents said they felt confident in their ability to do so. Considering the cost of college has grown by 6.08 percent per year between 1977 and 2024, who could blame parents for feeling this way? (Overall inflation was closer to 3.5 percent, for comparison’s sake.)
Closing that gap between the perceived value of college—and the economic opportunities it may open for those with college degrees—and the reality of affording it is where a consistent approach to planning and saving can help.
Many parents with college savings on the brain have heard of the 529 college savings plan, and for good reason. These accounts, which were first allowed after legislation passed in 1996, were designed specifically to encourage saving for college in a tax-advantaged way. They’re called 529 plans because their rules and provisions can be found in Section 529 of the Internal Revenue Code.
Every state has their own 529 plan(s), each with their own fees and investment options, but regardless of which state’s plan you use, any money you put in grows tax free and can be withdrawn tax free to pay for qualified education expenses. Unlike other types of savings and retirement accounts, 529 plans don’t technically have an annual limit on how much you can contribute, but if you put in more than the annual gifting limit ($18,000 in 2024) you’ll need to file IRS Form 709. Each state also has an aggregate contribution limit ranging from $235,000 to $550,000 as the accounts weren’t intended to have contributions exceed a student’s higher education expenses. However, since most folks won’t be amassing that level of savings, we’ll want to focus on other attributes of the 529 plan.
Key Attributes of 529 College Savings Plans
Tax-Advantaged Growth: The earnings from your investments grow tax-deferred, meaning they aren’t subject to taxes as you contribute. Also, withdrawals are tax free if the money is used for a qualifying higher education expense.
Simplified Investment Options: 529 plans typically offer age-based investment options like the target-date funds offered in most workplace retirement accounts. Other investment options are typically available as well, but the overall menu of options is usually limited for simplicity’s sake.
Tax-Deductible Contributions: Many states offer a state tax deduction for contributing to a 529 plan, but you must reside in that state to get the benefit. In some states, you may be able to deduct 529 contributions (often up to a limit) from your income, potentially reducing your state tax burden.
- Washington state does not offer tax deductions for residents because it does not have a state income tax.
- Oregon offers a refundable tax credit based on your income and contributions an.
Asset Ownership: The money saved in a 529 plan is considered your own asset, rather than an asset of the beneficiary (the student). This is advantageous in determining eligibility for federal financial aid for the beneficiary of the account.
Transferability: The custodian of a 529 plan (typically the parent or grandparent) can change the beneficiary on the account at any time. This means that an account can be re-registered to a sibling or other family member if the original beneficiary decides against college or has money left over after they graduate.
Tax-Free Withdrawals: All distributions from 529 accounts that go toward qualified education expenses come out tax free. The definition of a “qualified” expense has grown significantly over time and now includes things like vocational and trade school, online courses, and even up to $10,000 in student loans. Be sure to keep all your receipts in case of an IRS audit, though!
Beyond the 529 Plan
And what about other ways to pay for college for your kids or grandkids besides the 529? Other common ways to fund college include:
- Federal student aid/work study
- Merit aid
- Scholarships (private or awarded by their school)
- Student loans
- On- or off-campus job
- Cash flow from parent or guardian’s work income
- Financial assistance from grandparents or other family members
- Coverdell Education Savings Accounts (ESA)*
- Individual investment account*
- Roth IRA*
*The final three options on the list above are the other investment accounts most often used for college savings. They are less common but can have their place in the right situation.
- The ESA was first introduced in 1997 and functions similarly to 529 plans but with an annual contribution limit of only $2,000. These accounts must also be used up by the time the student turns 30 or the account will be fully distributed to the beneficiary as taxable income. The ESA has waned in popularity since its introduction, and we see it used sparingly today due to the low contribution limits and more stringent “use-by” date.
- An Individual investment account is a “non-retirement” investment account that anyone can open and contribute to, though it offers none of the tax benefits that 529s and ESAs do. However, the owner of the account (typically the parent) has total flexibility in how much they contribute, how it’s invested, and what the funds can pay for. We tend to recommend this option as a supplement to, or replacement for, the 529 plan if parents are unsure about their child’s educational future or if they’d like the ability to pivot and use the funds for a home down payment, a wedding, or helping their child start a business instead.
- A Roth IRA is a retirement account funded with after-tax dollars where the investments within it grow tax free. Assets in a Roth IRA are also withdrawn tax free in retirement. There is no penalty, however, for pulling out contributions made to the account prior to retirement, so we occasionally see Roth IRA money (whether the parent’s or the student’s) used to help fund college. We generally like to see Roth IRA money used in retirement to take advantage of the tax-free growth, but it can make sense in a college funding plan in certain cases.
Deciding the “right way” to save for college is a deeply personal choice and one that requires considerations both known and unknown. Our philosophy is that there isn’t just one ‘right way’ to save, and that for most families it will take a patchwork quilt of resources to help their child(ren) achieve their educational dreams. This type of conversation is a great reason to seek out a financial planner who can ask good questions, act as a sounding board, and provide nuance pertinent to your situation.
When working with clients we include college planning as a key piece of comprehensive financial planning, and we encourage you to reach out if this resonates with a need in your own life to see if we’re the right fit for you.
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