Today I’m talking about Grandparent 529 Plans.
In fact, a BIG change was recently that seemed to fly under the radar.
In addition to discussing this change, Robert Farrington joins me to discuss three (3) important things:
- How to maximize the tax benefits of a 529
- Why 529 plans are great estate planning tools
- How to invest your money inside a 529
We also talk about alternatives to 529 plans that retirement savers might consider.
If you want to learn about the new 529 rules + how to maximize the tax/estate planning benefits of these accounts, you’re going to love this episode.
Age 50+? Need retirement + tax planning help? Get a Free Retirement Assessment👇
How to Listen to Today’s Episode
- Robert Farrington:
- Student Loan Debt is a Burden for People Over Age 50 [AARP]
- 3 Things More Important Than a 529 Account [Stay Wealthy]
- Fidelity 2021 Age-Based 529 Mutual Fund [Fidelity Investments]
Grandparent 529 Plans: Big Changes + How to Maximize the Tax Benefits
Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m talking about 529 plans.
In fact, a big change was recently made to grandparent-owned 529s that seemed to fly under the radar.
In addition to discussing this change, Robert Farrington from the college investor joins me to discuss 3 important things; how to maximize the tax benefits of a 529, why 529 plans are great estate planning tools, and how to invest your money inside a 529.
We also talk about alternatives to 529 plans that retirement savers might consider.
If you want to learn about the new 529 rules + how to maximize the tax and estate planning benefits of these accounts, you’re going to love this episode.
For all the links and resources mentioned today, head over to youstaywealthy.com/156.
Investors who are in retirement or close to it, might think that 529 college savings accounts no longer play a role in their financial plan.
But just like IRAs and 401ks, 529s have many different use cases, and some of these use cases can help address and meet common retirement planning goals.
Some can also be helpful from a tax planning or estate planning perspective.
To help us dive into the world of 529’s, and specifically grandparent-owned 529’s, I invited a special guest to join me today:
Robert Farrington: Hey I’m Robert Farrington. I am the founder of The College Investor.
Taylor Schulte: Thecollegeinvestor.com is one of the top blog sites, if not the top, for all things related to college planning. And some of the most popular articles and resources published to the website are on the topic of 529 college savings plans.
529 college savings plans are state-specific, and they were originally created in the late 1980s to help combat the financial strain college put on families and students. Florida, Michigan, Ohio, and Wyoming were the states that played a major role in bringing these plans to life.
Since their creation, roughly 12 million families in the unites states have saved nearly $260 billion dollars inside of 529 accounts, or more formally referred to as Section 529 plans.
So, what exactly, is a Section 529 plan?
Robert Farrington: So a 529 plan is a special type of education and savings account that offers a ton of great tax benefits for saving for education. It used to be saving for college because this would be the account that you would want to use to save for college because any money you pulled out could be pulled out tax-free when used for qualified college expenses.
But over about the last 5-7 years, congress has broadened what you can use a 529 plan for. So now it’s really better to call it an education savings account because you can use it for K-12 expenses, you can use it for trade school, vocational school, basically the definition of what you can use the account for goes a long way.
But the money goes in potentially tax-free, or tax-deferred, grows tax-free in the account and as long as you pull it out for qualified education expenses it will be tax-free when you withdraw it.
Taylor Schulte: I know the stay wealthy community loves saving money on taxes, so let’s be sure we understand the tax benefits of 529 accounts. As I had mentioned at the top of the show, 529 plans are state-specific. So, while investments inside of a 529 account always grow tax-deferred (just like an IRA or 401k) and withdrawals that are used for qualified education expenses come out tax-free for everyone across the country, each individual state does have specific rules around the tax treatment of contributions to a 529.
Robert Farrington: A lot of states offer benefits for contributing to a 529 plan. So right now, 5 states offer tax credits to their residents to make contributions to a 529 plan, 29 states offer tax deductions to their residents for making contributions to their 529 plan. So in over half of the United States, you know, there is a good tax benefit for contributing to a 529 plan.
And then of course you do have the tax-free states anyways so there's a lot of tax benefits for contributing to a 529 plan that could lower your state tax bill. It’s important to note that there are state tax bills and state plans. The federal government doesn’t get too involved in 529 plan regulation and there’s no federal tax break for contributing to a 529 plan.
Taylor Schulte: For those that do live in a state that provides a tax deduction for 529 contributions, there’s an important, and sometimes overlooked, tax strategy for parents and grandparents to keep in mind each year. Here’s Robert with more…
Robert Farrington: There’s a huge benefit just putting the money into the account even if you were to say withdraw right away. So in some states let's just say that you are paying for education today, well you could literally just funnel the money through the 529 plan, I’ll put an asterisk there because a couple states do have a 1-year waiting period, but most of them don’t.
You know, you could put the money into the account, realize a state tax deduction, and then use the money out of the account, even if it doesn't grow at all you could still save some money on taxes.
Taylor Schulte: In addition to some states now allowing 529 plans to be used to pay for K-12 and apprenticeship programs, some also allow funds to be used for student loan debt repayment.
Robert Farrington: Congress with the secure act now allows for a $10,000 one-time use for repaying student loan debt. So again, it has the potential to let you use pre-tax money to repay some student loan debt. Or if we’re looking from a parent or grandparent perspective, it allows you to maybe gift some money pre-tax and hello somebody else repay their student loan debt, maybe a child or grandchild.
However, it’s important to note that not all states allow this. So again, these are state-based plans and so you need to check with your own state law. So this one is the one with the fewest number of states that allow it, only 23 states allow you to use 529s for student loan repayment.
Taylor Schulte: One really interesting thing I learned through my research for this episode was that student loan debt is not just a problem for our youth. In fact, of the $1.6 trillion in total student debt at the end of 2020, borrowers over age 50 accounted for about 22 percent of it or $336.1 billion dollars. And it’s a growing problem, with this number being 5x higher today than it was in the early 2000s.
Robert Farrington: The over-50 age group is the fastest growing cohort of borrowers in this country right now and its kind of interesting because it's like how do you still have student loan debt over 50 right?
So one, some people may have just been kicking the cans down the road but I think a larger portion of this cohort is actually parents that have borrowed for their children’s education. So as we talk about parents and grandparents saving for college, why does this generation also have student loans?
Well if they didn’t save for it or didn’t plan for it, a lot of them end up borrowing for it. And now as they approach retirement ages they're like what do I do with all this student loan debt as I’m looking at, you know, what’s in my retirement account, what do I need to live off of. And it’s really becoming a challenge, it’s one of the reasons I advocate, I’m a big believer that parents should never borrow for their children’s education.
I know that might be kind of harsh for some people but, I think parents need to put the oxygen mask on themselves, take care of their own plans, their own retirement because there’s a ton of ways to pay for college. They might not all be ideal or best-case scenario but there are a lot of options.
When it comes to your retirement, there are no options, you’re not getting a loan from the government for your retirement right. You’ve got to deal with your own house and make sure you’re good to go before that time comes.
Taylor Schulte: To make matters worse here, what many people gloss over is that student loan debt can’t typically be discharged through bankruptcy. In other words, if you default on federal student loan debt, the government can tell your employer to withhold your pay or seize your federal tax refund, or even garnish as much as 15 percent of your Social Security benefits.
In fact, in 2015, the most recent year I could find data for, roughly 114,000 borrowers over age 50 had Social Security benefits seized to repay defaulted federal student loans.
Robert Farrington: The collateral of the student loan is your future earnings. So we talk a lot about the mortgage, the collateral on a mortgage is your house, they foreclose it if you don’t pay it. The collateral of your car loan is the car, they’ll repossess it if you don’t pay it.
Well, I think one of the biggest missed arguments today about student loan debt is the collateral. The collateral is your future earnings. You borrowed this money to go to college, or a parent borrowed it, because the goal was to increase your future earnings because we’ve all heard the stats right. You go to college you make more than if you didn't go to college.
Well, on the flip side, if you don’t repay the student loans they will take your earnings to repay it. The government will, private lenders can sue you to get your earnings so that’s the collateral, I think it’s important to frame the borrowing conversation in that.
Taylor Schulte: Ok, with a solid understanding of 529s, what the funds can be used for, and how to maximize the tax benefits, let’s get into some of the big changes that specifically affect grandparent-owned 529 plans.
But before we do, you might be wondering what a grandparent-owned 529 plan is. To answer that question we have to first understand how 529 accounts are titled and owned to begin with because there are some unique characteristics.
So, when you set up a 529 account for someone, you have to choose a single account owner and a single account beneficiary. Just like an IRA or 401k, most 529 accounts don’t allow joint ownership.
For example, a husband and wife can’t both be the owners of a 529 account. You can, however, list one spouse (or one person) as the owner and the other spouse (or another designated person) as the contingent owner. That way, if something happens to Spouse or Person A, Spouse or Person B can immediately step in and take over the ownership and management of the account.
But unlike an IRA, where you can name as many beneficiaries as you want, a 529 only allows one beneficiary per account. You can change the beneficiary 1x per year, but you do have to name someone in order to get the account open and funded. Naturally, the beneficiary is typically the person (child, grandchild, niece, nephew, etc.) the beneficiary is typically the person you went to go set this account up for in the first place.
But, if you’re not sure who you want the beneficiary to be yet…or maybe you’re setting it up for an unborn child who doesn’t have a social security number yet…you can always name yourself as the account owner AND the account beneficiary, allowing you to get the account open. And then, when you decide who you want to name as the beneficiary or the child is born and has a social, you can swap the beneficiary and name that person.
What this all means, essentially, is if you want to set up a 529 college saving plan for 5 people, well, you’ll need to establish 5 different accounts, each with a single owner and a single beneficiary.
This ownership structure is often what makes 529 accounts so appealing. And that’s because the account owner not only gets the state-specific tax benefits (if they exist), but they also maintain control of the money contributed to the account. Even if the beneficiary listed is an adult, the account owner is still the one who gets to decide when and where to distribute the funds.
The beneficiary never has any say in it. Of course, the account owner will ensure the money goes towards qualified education expenses for the beneficiary because that’s why they set it up in the first place. This ownership structure allows the grantor – the person contributing the money – to prevent the beneficiary from using it to buy a new car or invest in cryptocurrency.
So, what then, is a grandparent-owned 529? It’s simply a 529 account where a grandparent is the account owner and their grandchild is the beneficiary, bypassing the parents in the middle. And this is common because the grandparent wants to maintain control of the money. If they made the parent the owner instead, the account and funds contributed are now owned by the parents.
And who’s to say the parent doesn’t liquidate the account to go on a nice vacation instead of using the funds to pay for the grandchild’s education. Sure, the parent would incur taxes and penalties on the liquidation because it’s not going towards qualified education expenses, but it’s not enough to stop or prevent someone with those motivations.
In addition to maintaining control, grandparent-owned 529’s have always been a hot topic because of how the assets inside of a grandparent-owned 529 are looked at and treated on college FASFA forms. Before we dig into those specifics, let’s quickly break down what the FASFA form is.
Robert Farrington: The FAFSA is the free application for federal student aid. So every 17-year-old and their parents will be filling out the FAFSA to see if they qualify for any type of financial aid. It's important to note that financial aid means scholarships that are both merit and need based, it means grants that are both merit and need based, and it means student loans, specifically federal student loans.
So if you want any of those things you have to fill out the FAFSA, the free application for federal student aid. Then this form looks at the parent and student’s income, it looks at the parent and student’s assets and then it comes out with a number at the very end of it called the expected family contribution.
And without getting too in depth, the bottom line is if you have a lot of income and assets you are expected to pay more for college and you will get less scholarships and grants and if you have very minimal income and assets you are expected to pay less for college and you will potentially qualify for more scholarships and grants.
The student loans doesn’t matter, need-based non need-based, anyone get a student loan but they have to fill out that FAFSA form.
Taylor Schulte: Maybe like you, when I hear student financial aid, I immediately think of lower-income households – families and students who are truly in need of financial help. But that’s a common misconception with regard to FAFSA forms.
Robert Farrington: The FAFSA is basically the key to unlock all these things. The schools will use it to determine their scholarships and grants whether that’s need or merit based. And then of course it’s basically your student loan application.
So even if you have plenty of assets, if the student needed a student loan, they have to have filled out the FAFSA and that’s a miss for a lot of students because they realize last minute “Oh my god I need student loans” and they try to rush to get the FAFSA done and get all the stuff approved before the deadline. This is the application you need for any of those things.
I also recommend that people fill it out every single year. So 17, 18, 19, 20-year old, every year of college just fill out the form. You might not get anything because you have income and assets but at the same token you never know. There are a lot of programs there's a lot of things available especially from colleges.
Yes it takes a little bit of time but once you do it once it's actually fairly easy you just repeat the process super simple. Spend 20-30 minutes of your time to fill out the form.
Taylor Schulte: It's important to clarify here that families who are receiving financial aid and want to maintain it, do need to submit a new FAFSA every year. But those who aren’t relying on financial aid at the moment might still consider tackling this complex form each year as well. Why? Well, as you can imagine, it’s hard for anyone to keep up with all of the opportunities and grants being offered by schools and partner organizations, and completing the form is the only way to know for sure if there’s something out there you, specifically, might qualify for. But Robert shares a couple of other good reasons as well:
Robert Farrington: One you might start off as a dependent student in year one and two and maybe you become an independent student in your remaining years. Maybe your income changes maybe the parents’ income changes or assets change. There are a lot of variables, it doesn’t seem like a long time but four years is kind of a long time especially if you’re thinking of four-year college career.
Taylor Schulte: As noted, and as some of you may have experienced before, the FAFSA form takes some time to complete given the amount of information collected. In addition to the basics, (name, social, date of birth, etc.), families are required to supply information on their income and assets, including bank accounts, investments, real estate, and certain types of businesses they own. And this is where things get interesting, specifically as it relates to student assets vs parent assets vs grandparent assets.
Robert Farrington:The FAFSA looks at both student assets and parent assets and depending on how the 529 plan is owned it can be reported as a parent asset or a student asset. If the student is a dependent student or the parent owns the 529 plan the student owns the 529 plan and they’re dependents, it's a parent asset. If the student is an independent student it’s reported as a student asset.
Here’s the cool part, if it's owned by anyone else, for example a grandparent, it’s not reported as an asset right because it doesn’t fall into the student or the parent bucket of how it’s treated. So, why this matters is because if the asset is a student’s asset it’s their money, it counts a lot more on the FAFSA, it counts up to 20% of the asset value. However, if it’s a parent-owned or a dependent student-owned asset it only counts as 5.64% of the asset value. So that’s all they’re going to count towards paying for college so it's significantly less.
And then of course if it’s a grandparent-owned asset it counts as 0 on reducing any financial aid. So this can really play a role into how much need-based financial aid a student receives.
Granted, if there’s a lot of money in either parent or student’s wheelhouse, probably not going to get much need-based financial aid. But if there’s not a lot of money there in assets and income and the 529 plan is really the bulk of the assets it really isn’t necessarily going to impact them very much. So it’s something really important to consider as you’re saving.
Now granted if you just start early and this 529 plan grows, well who cares right, it's going to cover the cost of college you don’t need to worry so much about need-based financial aid. But if you’re starting late or there are other situations, it might be something that you want to think about and that 529 plan is one of the best ways that you can save for college because it has the least impact on need-based financial aid.
Taylor Schulte: Historically, grandparent-owned 529 accounts impacted a student's eligibility for financial aid more than parent-owned accounts. For that reason, grandparents, in many cases, chose to go ahead and relinquish account ownership to the parent, even though it meant losing control of the money. But, thankfully, that’s changed, and those changes, while they have caused some confusion, do in fact go into effect this year.
Robert Farrington: Starting with the 2024 FAFSA, qualified distributions from a grandparent 529 will no longer count. So it’s important to note that if the grandparent owns the asset, it wouldn’t have counted on an asset picture today.
But let’s just say the grandparent took out $20,000 to help the child pay for college. Well all of a sudden that student now would have to report $20,000 of income for the year. So it wouldn’t affect the first year’s financial aid picture.
So let’s just say it’s a freshman, it wouldn’t affect the freshman year but then when they go to fill out the FAFSA for their sophomore year all of a sudden they would have had $20,000 more in income because of that distribution. And that could have negatively impacted any financial aid they were receiving in year 2.
So a lot of people are getting surprises right, they’re like “oh I can pay for college, everything is great, I’m going to start as a freshman” and then all of a sudden they go to their sophomore year and they’re like “woah woah woah” they had to come up with a bunch more money and that was not expected.
Well, starting with the 2024 FASFA, any distributions from a non-custodial parent or grandparent or aunt or uncle are not going to be reported as either an asset or the distribution is not going to be reported income. You might be thinking “woah it’s only 2022 when we’re recording this podcast, 2024 seems so far off.”
Well remember, the 2024 FAFSA you’re going to apply for in 2023 and you’re going to be using your tax returns from 2022. So that’s why this year, as of now, those distributions will no longer affect financial aid eligibility in the future.
Taylor Schulte: In addition to using a 529 to help save for and fund education, many families also use them for estate planning purposes. Some tax experts say it’s one of the most underutilized estate-planning techniques. And that’s because the money in a 529 account is exempt from federal estate tax, and therefore, the dollars inside the account don’t count toward your taxable estate.
Now, the federal estate tax ONLY applies to estates that are worth over $12.06 million, or $24.12 million for a married couple. While a very small % of Americans are currently above those limits, it’s important to know that, as it stands today, the limits are set to drop to the $6 million range in 2025. And, these limits can and do change quite dramatically. You might remember in 2005 when the estate tax exemption was $1.5MM. So, don’t get too comfortable with the current amounts, as they are far from being set in stone.
Also, there are other QUOTE “death taxes” that are separate from federal estate taxes and don’t fall under the same exemption limits. For example, 13 states have a state estate tax and a few even have an inheritance tax. If any one of these death taxes might apply to you when you pass away, getting money into a 529 account, an account that is held outside your taxable estate, might be a wise move.
Robert Farrington: Yeah, so I mean, I think we kind of all know when it comes to estate planning either you give it away or the government going to take it away. So if you’re looking at ways to gift but you also want the gift to go for a cause, an education savings plan can be a really interesting tool for grandparents to save for college.
So, just so you know there is a limit on how much you can contribute to a 529 plan, there’s actually two limits.
The first limit is really the gift tax exemption level. Which as we’re recording this I believe it’s $16,000 this year in 2022. A couple could give $32,000, if I’m doing the math right there, to 1 529 plan per year. But 529 plans also allow what’s called super funding where you take a 5-year contribution which I believe now would be $180,000, maybe not, don’t quote me on that, if you make a 5 year contribution at one time to 529 plans.
So let’s think about a situation where a grandparent might have two children and each of those two children have two children a piece so maybe there’s 6 dependents. Well you could start gifting out significant chunks of money to these people and they have to be used for education right. So if that’s a value you have in your family or you just don’t want them to blow it on a car or who knows right, these plans really only work for education.
One of the things we didn’t really touch on was if you take the money out for non-qualifying expenses you’re going to get hit with taxes and a 10% penalty. So, it doesn’t make sense to use these plans and accounts for non-education expenses. If you want to use it for education, the money goes in it can be withdrawn tax-free and you can contribute significant amounts.
It depends on your state but the maximum amount that you’re allowed to have in a 529 plan until they no longer allow you to contribute varies anywhere from $300,000-$500,000 depending on your state. But that doesn’t mean the money won’t grow. That just means that you can no longer make contributions to your account.
So you could potentially gift a sizeable amount to these plans and realize that into the future you can change beneficiaries you can change account owners. So I’ve seen families that actually use a 529 plan as effectively an education trust. You can superfine these things put a ton of money into them, they grow for years and years and years, and then just over time these families change the beneficiaries to reflect who needs education.
And it can be a great way to not only take the money out of your own estate but you’re putting it into a cause that you might value as a grandparent. Here’s where it can really be interesting, is you have a child and potentially a grandchild is you let the money sit there, let that money grow, maybe the child or the grandchild goes to school, maybe there’s still money left over. There’s nothing to say that you can’t transfer the ownership to that grandchild
Taylor Schulte: While 529s have their fair share of benefits, they aren’t the only tax-friendly option for parents and grandparents to help save and pay for education expenses. It’s important to weigh all of the options, and understand the pros and cons of each, before blindly opening a 529 account because it’s the only solution you’ve been presented with.
Robert Farrington: So, the Coverdell was like the original education savings plan. They’re attractive in some ways, but since 529 plans have grown in what you can use them for, they’ve become less and less attractive over time. You actually rarely hear about them coming up too often anymore.
The big benefit with the Coverdell is that you can use it for unlimited amounts of K-12 education funding. So the 529 plan you can only use $10,000 a year for K-12 tuition only. That can be a limit especially some of these private schools at K-12 might be $20,000 or $30,000 a year. That can be a challenge of a 529 plan whereas a Coverdell has no limit on what you can use for K-12 but they do have a limit on how much you can contribute.
This is the flaw, is there is a $2,000 annual contribution limit per beneficiary. So even if you’re thinking about an expensive private school, is your money going to grow enough or even potentially cover the cost? It doesn’t get you very far so that’s a problem there.
You also have a UGMA, UTMA custodial account so there are just taxable accounts but they can be used for anything. The cool thing is it's just a taxable brokerage except it's held in a custodial account for the child. So there are some implications potentially with the kiddie tax and other things that could be a negative, right, for this especially if the balance gets sizeable and there are dividends and growth and sales happening.
But on the flip side, there’s no limitation, right? So because it's just a brokerage account in the child’s name you can use the money for anything or the child can use the money for anything. That‘s a benefit and also when we’re talking about the FAFSA, custodial accounts are considered a student asset so when we’re talking about what’s the worst asset to hold on the FAFSA well the custodial account is the worst to hold.
But on the flip side, if there’s a significant amount of assets in the custodial account, well, it doesn’t matter but they are going to be counted the most penalty basically is a custodial account.
Finally, you have the Roth IRA lot of people talk about “oh using a Roth IRA to save for college” because one of the benefits of a Roth IRA is that the early withdrawal penalty is waived if the money is spent on higher education expenses. So you're like “oh we can use a Roth IRA to pay for college.” That’s great but I always like to say “who’s Roth IRA” first off. So a child’s Roth IRA or a parent’s or grandparent’s Roth IRA, it all makes a difference.
One, a child how do you get money into the Roth IRA, it’s relatively challenging because the child has to have earned income. They might not start getting earned income until later in life, is the money going to grow.
Then part two is Roth IRA money used to pay for college is going to be counted as income the second year, so it’s that same problem we talked about earlier where in year one it looks great but then when they pulled the money out of Roth IRA in year two, it’s going to be income for them so they might reduce potential financial aid going forward.
Finally, for grandparents, I think this is one that’s just not touched on a lot but it’s important to note, and it's not an education savings account or anything, but grandparents can pay for college tuition and it’s not subject to the gift tax or the gift tax exemption. As long as you write the check directly to the school, that’s just it, you’re just paying for education.
So, if a grandparent does have a lot of assets and there’s a grandchild or child that's going to college, you can avoid all this too and you literally could just write the check for college, and it’s very possible to do. Depending on your situation, that might be the easiest, it doesn’t set up a legacy it doesn’t do anything in that regard but you don't have to worry about gift tax or anything like that. You can literally just write the check to the college.
Taylor Schulte: Speaking of just writing a check to college, some of us can’t help but wonder, what if our child or grandchild doesn’t need or want to go to college? What if they want to start a business? Or what if they gravitate towards an untraditional online curriculum that isn’t considered a qualified education expense?
Robert Farrington: And that’s honestly the number one hesitation I think of all of these college savings accounts right, is “what if my child doesn’t go to college.” And that’s kind of the trend too that we're just hearing in the public discourse like what’s the value of college today, yada yada right. I think it’s important to note that one of the things we’ve been seeing over the last few years is this trend of allowing more and more options for using the 529 plan.
Like I said, back in the day it used to be qualifying college expenses only, today we see qualifying college, K-12 tuition, you can do it for vocational school, and apprenticeships, you can use it for student loan repayment. And I do see this trend continuing to increase. Now, will it just be allowed to use for anything, probably not, but I do see it continuing to expand to be able to use for education holistically in a lot of ways.
So I think that is one of the biggest things. I think part two of that conversation is, what is the worst-case scenario? The worst-case scenario is that you pay taxes on your earnings and a 10% penalty on your withdrawals. That’s your worst case, that would suck, it’s not great. But that assumes that you never transferred the money to somebody else, or used it for another child, or let it grow for grandchildren. So again if you’re thinking about gifting this, maybe grandchild A doesn’t ever go to college, but that's not to say that grandchild B or C couldn’t leverage that as well. Or that’s not to say that great-grandchild A doesn’t go to college and the money just grew for an extra 25 years. There are a lot of options in that regard of how you leverage these funds.
Taylor Schulte: The last thing to really understand with regard to 529s is how the money is managed and invested inside the account. More often than not, the investment solution that most 529 account owners opt into is what’s known as an age-based mutual fund, also known as a target date fund in the retirement planning world.
Just like a traditional target date fund that you might be familiar with, age-based mutual funds take risks off the table and get more and more conservative as you get closer to the designated date.
For example, if the beneficiary of a 529 was just born today, you might choose a 2040 fund. Because, in the year 2040, that child will be 18 and headed off to college. The 2040 fund will be fairly aggressive and risky today, but each day, very very slowly, the fund will rebalance into more conservative investments, so that by the time the funds are ready to be used by the year 2040, most of the money is safe and secure.
However, as I’ve noted in prior episodes when talking about target date mutual funds inside your retirement accounts when you look under the hood of these age-based funds, they can oftentimes be more aggressively positioned than you might have assumed, even by the time they reach your targeted date. For example, the Fidelity 2021 fund, intended for students who started college last year, is down almost 10% this year.
My guess is that you probably wouldn’t want the funds that you need to use right now to pay for college to be losing money. Unlike retirement, college only lasts 4-5 years – you don’t have a long runway to dynamically and systematically withdraw money to cover your expenses over a 30 or 40-year time period like you do with your retirement dollars.
For that reason, I often suggest that parents or grandparents, or 529 account owners, consider moving some or all of the money into cash when the beneficiary is 1-3 years away from needing the money. Sure, you might miss out on a few percentage points of growth if the market remains in your favor, but losing money will be 10x more painful.
Robert Farrington: I mean I think you nailed it. So just like an IRA or other account, you know, you make your deposit into your 529 plan and it basically sits there until you allocate it to an investment. So one, please make sure you do allocate it to an investment, unless you’re funneling the money through these accounts.
But yes, all of these plans are state-based plans and each state gets to decide on what their investment choices within the plan are. I’d say most states offer you like 5 to 8 different funds to invest in. You got your basic total stock market bonds fund, usually like a cash savings account fund.
Then most of them do have target date funds like you mentioned. It’s important to note though, the target date is the date your child starts college, it’s not like a retirement fund. So you need to kind of think about when they’re graduating high school, what year that is, and that’s the date you’re looking for not anything farther than that. You need to just pick those funds, but, I do think the important thing to look at too is fees.
So, one of the things that when it comes to these funds, or one of these state plans, is that each state gets to set up their own plan. And for those of you that receive tax benefits in your state, well it might just make sense to contribute to your state’s plan no matter what the cost of the funds is. Simply because the tax benefits outweigh any extra basis points that you’re paying in fees.
If you’re saving, you know, $500 in taxes every year, well the fees that you’re going to pay aren't going to offset that. But on the flip side, if you’re in one of these states that doesn’t offer any tax breaks or maybe you’re in a no-tax state. The best thing you can do is look for the 529 plans that have the lowest fee structure. So 529 fees are super complicated and sadly, they are 5 times more, on average, than you can expect to pay for your retirement plans.
And it’s really disheartening in a lot of ways because I will tell you that some states leverage their 529 plan fees to offset their budget costs. Other states don’t, some states are great right, but some states do. So I would look at your fee structure because most 529 plans don’t just have the fund fees.
So your listeners are probably familiar with expense ratios and what the fund fees charge but then there’s usually also a wrap fee and a plan administration fee around all of that and that’s where that money typically goes right back to the state or is split 50/50 with the state or the plan providers or other ways. It’s supposed to be used for marketing and things like that but historically it’s not necessarily done that way.
So, look at minimizing fees because some of the worst states charge well over 1%+ in fees on the 529 plan and they’re not offering anything better than the best states. You look at these fee structures, go to the plans that have the least amount of fees because you typically don’t have a lot of time. You need the money to grow you want it to be used for college.
And then on the flip side if there’s a lot of money there and you want it to grow and be a legacy for your family, you don't want that legacy to be eroded by fees that go to state governments that are using it for purposes that really don’t make any sense. So keep that in mind as you're looking for your plans.
Taylor Schulte: I know we covered a lot today, but before I let Robert go, I asked him to summarize a few key points and also share some of his favorite resources for those that want to dive deeper.
Robert Farrington: Yeah I think the big thing is understand the rules in your state. So we touched on this a few times but, you know, there are 50 states there are 48 plans. Wyoming and one other state they just decided to not have their own state plan and they let you go anywhere. But know what your rules are because the rules for taxes and tax deductions and contributions and all of this are dependent on the account owner's state.
So this is important to remember so whoever’s owning this account the rules are based on your state that you’re in so as you open your plan and figure out which tax deduction stuff, know your state’s rules, know what your tax deductions are know if you’re allowed to use it for K-12 education or you’re not. I hate to see you get into this and realize that like “hey none of this applies because I’m in California” or something similar.
We have a full list on the college investor, you can go to collegeinvestor.com/529planguide you can find your state there but there are other resources as well. But just make sure you know what state and what you’re able to do in your state.
Taylor Schulte: Once again, that’s Robert Farrington, owner of thecollegeinvestor.com which is currently read by over 1 million people PER MONTH.
I’ll be linking to a number of his resources on college savings accounts and 529 plans in the show notes which you can find by going to youstaywealthy.com/156.
Thank you as always for listening, and guess what, I have another bonus episode coming out in two days. Be sure to tune in because I have a fun announcement to share.
See you then.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.