If you have children, you’ve probably started thinking about saving for college. How about a 529 plan? It’s a great tax savings seeing how you can invest money, let it grow, and be able to use the money and its gains tax free for educational expenses.
529 Plan vs A Regular Savings Account
Let’s walk through a possible scenario. Making it easy, let’s say you open two accounts, one 529 and one regular savings account with $10k each, make no additional contributions, and they grow for 16 years. Note: no estimate for annual account fees, etc, is in included here.
529
$10,000 initial contribution
0 additional contributions
7% interest (average stock market rate over the years)
$29,521 – value after 16 years (gain of $19,521)
-$1,952 – 10% penalty (on the gain of $19,521)
-$4,880 – 25% ordinary income tax on $19,521
$22,689 – final value (est w/o annual fees and such)
Savings Account
$10,000 initial contribution
0 additional contributions
1% interest rate (highest rate you’d find today)
$11,725 – final value after 16 years
What a difference! Know, though, the stock market isn’t consistent. The 7% is an average over decades of tracking. Which is good for long term investors because 7% is pretty good. But the market is still volatile. It may be in a low year when you need to pull the money for school. If you’re not going to use it for school, you can always leave it in the account until a good year comes up. There’s no time limit for leaving it in the account.
What if my child decides not to go to college?
This is the biggest concern most people have when contemplating opening up a 529 plan. There are alternatives, however!
- The money can be transferred to another family member. You can even use the funds to go back to school yourself!
- The money can be used for trade school instead.
Penalties if neither option above works
Worst case scenario there is no one to transfer the money to and your child doesn’t use it. In that case there would be a 10% penalty to pull the money out in addition to having to pay taxes on the gains made. The 10% penalty is only on the gains, not the entire amount in the account.
Keep in mind the tax part you would have to pay regardless of this or any investment in an ordinary account. So really, it’s just the 10% penalty you would incur for withdrawing for non-educational related purposes.
Penalty Example
Say the account increased in value by $5000 over the years and you withdraw the full amount. There will be a $500 tax penalty (10% of the $5000), leaving you with $4500 (will be a little less after brokerage company fees). You will be taxed at your current tax rate for the $5000. Say you’re in the 25% tax bracket, that means you’ll be taxed $1250 ($5000 x 25%). You’ll account for it when you do your taxes for that year.
Retirement first, then 529 plan
Before you think about opening a 529 plan, however, be sure you’re saving for retirement fully. If you already are, great. Keep going with it. Otherwise, start saving now before saving for your children. That’s selfish, right? Not really. Ask yourself this – do I want to be in a position where I HAVE to work after retirement age even if I don’t WANT to?
You can’t borrow for retirement, but your little one can borrow for college. If you’re not in a good place yourself with saving for retirement, you should take care of that first. Your child can always take loans and look for scholarships (there are tons out there, many of which go unclaimed) for college. And once you’re set up with a secure financial future you can always help your children pay off their loans.
Does anyone have any of their own experiences with college savings they’d like to share???
