Should I start a 529 college saving plan for my baby?

With the tax advantages of a 529 plan, parents might have a hard time choosing between reaching a college savings goal for their kids and retirement investment account goals for themselves.

Is education savings more important than your own retirement? Learn more.

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Once you know you’re expecting a baby, you will be inundated with all sorts of offers to assist in the financial wellness of your baby. Education savings plans will be among the many investment options that you might be asked to consider on their behalf. But now that means you’re splitting your income between your investment options that fuel their future over yours.

From mutual funds to life insurance to 529 plans, parents should know that it is difficult to navigate where to put their money. It is very hard to figure out the best route to serve you and your family over the nearly 18 years that you have until your children reach college age. Many families are told that they should be creating a 529 plan for their baby because there are federal tax benefits for such education savings plan accounts. But does it really help set your baby up for financial success? Here are some things to consider.

Preggy Finance: Considering a 529 College Savings Plan for Your Baby

What is a 529 college savings Plan?

The 529 plan is a tax-advantaged savings plan to help people save money for their child’s future education expenses. The plan can be used for tuition and qualified higher education expenses. Recently, they also included apprenticeship education as an eligible use for this kind of education savings plan.

There are there is more than one type of 529 plan: Education Savings Plan and Prepaid Tuition Plan. They both have different methods of operation depending on the state.

529 plans can be purchased from your state, broker, or financial advisor. While they are open for everyone, it’s set up by mostly parents and grandparents for their kids and grandkids, respectively.

This plan was enacted by Section 529 of the Internal Revenue Code. So, to reap the benefits of this plan and have fewer worries about educating your children through college, you should set it up as soon as possible.

 

Preggy Finance: Exploring the Advantages of Starting a 529 College Savings Plan for Your Baby

What are Education Saving Plans?

These tax-exempt investment accounts go by many names. A 529 plan is just one of many types of plans, including Coverdell accounts and Custodial Accounts.

These are accounts opened specifically for educational expenses. They are opened by an adult on behalf of a child. The account owner is the adult who opened the account. The child would be the beneficiary. The adult retains control of the 529 plan.

Education savings plans are a bit different from prepaid tuition plans, which allow parents to purchase credits or units at the current price (not the future price when their kid later enrolls in college). These prepaid credits can be used to offset tuition and other mandatory fees.

Education savings plans can be used for K-12, college, graduate school, and even apprenticeship programs.

Why should I set up a 529 for my child?

One of the benefits of 529 is its tax advantages. If used to cover qualified education expenses, there are many tax benefits. Typically, a 529 plan is neither subject to federal income taxes nor state income taxes.

It’s easy to open a 529 plan. Most banks offer 529 plans so you can easily open an account online. You can choose the automatic investment plan and link it to your bank account, then simply set it and forget it. It doesn’t require much effort to keep a 529 plan going.

Unlike other accounts, 529 plans typically do not have an annual contribution limit — although they do have aggregate contribution limits that vary by state. Fees, federal, and state tax may apply if limits are exceeded.

It is flexible compared to other similar accounts. This means you can transfer it from one child to another if the first designated child doesn’t further their education, has the money, or is granted a scholarship. Your child can also use the 529 plan funds for apprenticeship programs.

 

Preggy Finance: Exploring the disadvantages of Starting a 529 College Savings Plan for Your Baby

What are some disadvantages of a 529 plan? 

Some people want more control than a 529 plan offers. Each is governed by rules that you do not set or adjust according to your individual liking.

Some plans are flexible enough to be applied to another sibling if the child named on the 529 plan chooses not to pursue education. But, if your kids don’t incur college expenses or get merit scholarships, you can’t access 529 plan funds without paying a penalty fee and federal income tax. The tax advantages largely go away, as tax free withdrawals only apply for qualified education expenses.

529 plans can cause your expected family contribution (EFC) to increase. Every 529 plan is associated with an account owner, using their social security number. So, the funds that have been in the 529 are considered an asset that college financial aid offices know can only be used as education savings.

Because the account owner can’t skirt this disclosure, having cash stockpiled in a 529 can drastically reduce the chance that your child would qualify for financial aid programs. This especially hurts middle class families that have some money in their education savings plans but not nearly enough to cover the expenses of a full degree. They can create debt for the account holder, who would be subject to student loan repayments.

What are the Tax Advantages of 529 Plans?

There are multiple tax benefits. According to the IRS, “A contribution to a [Qualified Tuition Plan] QTP is generally not subject to the gift tax if the amount contributed is less than the annual gift tax exclusion.” Because 529 plans essentially are a gift from a parent, grandparent or loved one, it is considered a gift. But generally, the gift is not tax deductible for the giver (unless it is given to a non-profit organization). Learn more about gift tax from the IRS.

Withdrawals under 529 plans are not typically subject to taxation. Tax-free withdrawals for high school or even college expenses can really make parents’ out-of-pocket costs much more affordable. It is much easier to reach college savings goals when the funds are not subject to state income tax and other kinds of deductions.

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What are 529 Plan Transferability Rules?

The SEC updated its guidance on this in 2023. 529 plans have specific transferability requirements regulated under federal law. The account holder may move to another 529 plan if there is no beneficiary change. (Remember, account owners are the parents, grandparents or guardians and beneficiaries are their kids).

You may also transfer the plan to another child in the same family.

Last, if there are any left over funds, the beneficiary may be able to roll over those funds into a Roth IRA. Talk with your tax accountant to learn more about the pros and cons of any of these changes to the original education savings plans you set up.

Some of these transfers to your 529 plan may be subject to fees or federal income tax.

How does the IRS define qualified education expenses?

The IRS updates its regulations regularly in the internal revenue code, so you’d need to check their website to know the latest. The qualified tuition expenses list was updated in 2024. Any updates on prepaid tuition plans and education savings plans would be on the IRS website!

529 plans can generally be used for primary, secondary, and tertiary education — including college, university and vocational schools.

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Is a 529 plan better than mutual funds?

This is a hard one because no one can predict the future. Education expenses are simply not going down in the US, so parents are often trying to save to beat inflation. Every 529 plan offers its account owner some benefits on their ordinary income taxes, and that can really make a difference for some parents over the years. Mutual funds don’t typically offer the same tax advantages.

In short, a 529 plan is neither better nor worse than a mutual fund. Each saving and investing mechanism is a tool to power your life. Work with a financial planner and a tax specialist to review your tax deductions, especially on federal taxes, to decide where you will get the most bang for your buck in the long run.

Should I prioritize my child’s college fund or my retirement?

If you’re choosing between your retirement or investment objectives and your children’s education, that’s a tough spot to be in. You don’t want to lose money either way, but no one has a crystal ball. So cut yourself some slack if it’s hard to know if future tuition or future cost of living will take the cake.

Although the price of private colleges in the US is eye-popping, you kids have many options to defray exorbitant college costs. Community college, scholarship funds, and grants may be available. By contrast, if your job doesn’t offer a pension, then chances are your retirement needs to be predominantly funded by the income you earn today.

You’ll need to do the math on how many years away from college they are versus how far away you are from retirement. If you’re largely on track for your retirement goals, then the retirement investment option may be less urgent.

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Ask yourself these questions:

  • How many more years do you need to work to withdraw funds from your retirement accounts without any penalties?
  • Have you maxed out the contribution limits for your retirement in the past?
  • Do you have a Roth IRA account that is already giving you some tax benefits?
  • Are you eligible for a pension at a certain age? If so, can you afford to stop contributing to your retirement fund and push that money to a 529 plan account instead?
  • Is your child open to college education or educational institutions abroad? High-quality higher education expenses typically cost much less in places like Europe and Asia.
  • Is your child going to be eligible for federal government benefits or low interest loans? If so, they may not need as much money in their 529 savings plans to pursue their educational goals.
  • Will the money paid into your current retirement accounts last you for the full length of your retirement? If not, could you go back to work or generate money in some other way?

Only you know the answers!

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Only with introspection can you decide if education savings plans are really meeting your overall financial goals for your family.

Do the math!

But if you get creative, there may be other ways to get ahead on both. Real estate investing may prove just as effective as a 529 plan. And it is more versatile — offering liquidity in case of emergency. You can use the money for more than just education expenses. Rental properties qualify for a tax deduction too.

Your job’s 401k or TSP plan also has tax-deferred or preferred benefits. Such plans often have a company match as well. If choosing between your child’s education and your retirement, you may want to contribute up to the company match so that you can get that “free money” boost in your retirement savings, even while prioritizing your child’s education expenses.

Many people find that prepaid tuition plans have a broad appeal, but they are only useful if you can predict your child’s educational ambitions. But even if your kid isn’t destined for college, you can still use 529 plan funds to offset the qualified expenses even for secondary school.

Qualified educational expenses can run the gambit from registered apprenticeship program expenses to fifth-grade school supplies.

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