In this episode, Scott discusses what 529 Plans are.
Some topics covered:
How's it going everyone. My name is Scott Bennett, and thank you for tuning in to the 3rd Decade podcast. Today, we're gonna be talking about the basics of 529 plans, which are a type of account used for educational savings. The idea of 529 comes from various s tates, prepaid tuition plans, and were developed to help people battle the rising c osts of college. We all know how expensive college is getting, and it continues to go up. So the government basically said, and it started with the states. Actually a few states said, oh, w e, we have an idea on how to address this. And, u m, there were prepaid tuition plans, which are still available, not nearly as widely used as 529 plans. And they have their own set of r ule a nd, a nd their own limitations as well. 529 plans were, how do we give mostly parents i s who they were designed for, but we'll get into a lot of other people can establish them. How do we give them a tool in order to battle these rising costs? So how do they work? I think the, the best way to do this is I was thinking about how to talk through 529's is to use my own family as an example, because we're a pretty typical case, I think in terms of 529's and starting one, when my daughter was born, my wife and I identified that we wanted to start saving for college. We've talked about the power of compounding when it comes to retirement savings extensively in the 3rd Decade program, same principles can be applied to college savings just usually with less time, obviously you have from one or two or three, or maybe even 4, 5, 6 years old to 18, usually to, to really take advantage of that long term compounding. So around my daughter's first birthday, we opened a 529 account with her as the beneficiary. This is one of the first specifics about five 20 nines. That's really important that I want to touch on the account holder. Usually the parent has control and discretion of the account and will name a beneficiary. Usually their child. Now, as I said before, it's not always the parent, actually anybody can open a 529 account for, for somebody else and name them as the beneficiary we'll get into why you wanna be a little bit careful about Willie nilly opening up 529 accounts for any, any friends or family or anything like that, because there are rules to how that beneficiary is treated in terms of how that money can be transferred. And, we'll get into that a little bit later. So we live in Arizona, but after doing some research, we found that the, my 529 plan had low fees and offered some really good low c ost investments. Again, the same standards we look for when evaluating where to open up retirement accounts, like a Roth IRA, this leads to the second important distinction, about five 20 nines. Each state has their own plan. Now that's, that's pretty unique. Uh, this doesn't mean that you have to necessarily use your state's plan. I just said we of in Arizona, we didn't use Arizona's plan. The, my 529 plan is actually Utah's, college savings plan. But if you do use a plan, you, you don't necessarily in a different state, you don't necessarily have to, or your child or, or the beneficiary doesn't have to go to school in that state. I say that, but please be aware that there could be some state tax benefits and also some, some individual scholarships and stuff used for, let's say, you live in North Dakota and, a nd the state of North Dakota. I don't know if this is the case. They might say you get a little bit of a tax break on your state taxes by using North Dakota's 529 plan, or you, your kid might be eligible for this scholarship by using our 529 plan. So the idea is to start with your state and your state's 529 plan, do some research into that plan. See if that makes sense for you. What are their fund options? Do they have low cost diversified, uh, mutual funds? Are there lots of expenses to run the account itself? How easy is it to navigate, make those decisions that you use when opening any type of account start with your state? If the answer is no to a lot of those questions, you wanna start looking at other states, but as I said, be aware of the benefits of using your state's plan for not all states even have benefits for using their plans, um, but be aware of them. So five 20 nines are so useful and the basis of how they work is money is deposited into the account. So we opened the account for my daughter. We deposited some money into that account and that money, as long as it is used for qualified education expenses can be the growth can be tax free. Uh, so it's, it's like a Roth IRA, but for educational expenses instead of retirement. So when we opened the account around my daughter's first birthday, we had about 17 years before we were planning to use that money. We first had to decide much, we wanted to deposit into the account and ended up doing a small lump sum as an amount each month. Um, so we did a small lump sum at the beginning, kind of a jump start. And then we said, we wanna do an amount each month. We built it into our financial plan. And we said, let's do a certain amount each month, um, that we feel comfortable, that works into our plan. Once that money was deposited, we directed how to invest in. I'll get to that in a second. And I wanna touch on, on how to get to how much should be in the account. There are a lot of college savings calculators online, where you can input income, um, your state you're in et cetera, and, and get estimates for how much college might cost your, uh, the beneficiary in the future and how much you'll need to reach to save your goals. But please be aware that these numbers will look really high. So try not to panic. Uh, and when doing your research, just do some search and, and have an idea of, okay, what are the projections of how much college is gonna cost me now for, for my wife and I, there was a pretty big difference between what of, you know, paying a hundred percent for our daughter's college was gonna cost versus what we could afford, but we said, well, let's save into it anyway. It's not like all or nothing for us. We said, let's, let's start saving, let's start, um, doing this. So, so she'll at least have a jumpstart and have something and hopefully scholarships and other things, uh, will take care of, of some of those other costs. So that was important to us now, like our case, there's a big difference between what you can put into a 529 and what you're allowed to put into a 529. So my wife and I could not put in a ton of money, but we, we said again, it was worth it. We were allowed to, the rule said we could put in hundreds of thousands of dollars. I just say that in case yourself or family member might be in a position to add a lump sum to the account, the contributions amounts and 529 plans are typically really high. I'm talking the hundreds of thousands of dollars. Each state plan again is different, but be sure to check what your plan's maximum contribution per year is. So knowing that we had 17 years, we decided to invest the money in low cost stock mutual fund, because we still had time until we needed to tap into that money. So again, the same principles as when we're thinking about retirement, we can take on some more risk. We can invest this money and stock mutual funds, um, because we have 17 plus us years until we're gonna need to tap into it. As our daughter gets older, the investments will get less and less aggressive. So less stock, uh, in the mutual funds and more bond mutual funds, et cetera, et cetera, they won't have the same potential for growth, but we'll also be less volatile and will also have, um, less risk associated. The more bonds we can them the, into the portfolio. Please note that a lot of 529 plans have the, the option to select automatically enroll in a plan like that, where you'd say your child's age, they're gonna start pretty aggressive and get less and less aggressive. The closer you get to college. So really kinda wipe your hands of having to monitor that, which can be really helpful. So we've established the account. We started saving into it. We invest the money for l ong t erm growth and we'll get less and less aggressive the closer she gets to college right now, when she's in college and needs t he money. How does that work? As I said before, if the money is used for qualified education expenses, both your initial deposit and the growth a nd the money can be used tax f ree, this is the huge upside of 529 plans. The list for qualified education expenses is pretty broad and includes like tuition books, things you would think that qualified education expenses are, but it's important to check what those qualified expenses are before deciding to spend the money. You wanna make sure that this falls within the qualified education expenses. So you use that money tax free and not get a penalty on it. If you use the money for something other than qualified education expenses, you not only have to pay taxes. There is also a 10% penalty. I've, I've touched this whole time on college savings. Um, that's what 529 plans were initially kind of primarily designed for. It's still what the vast majority of people use them for, but I would be remiss not to say the rules have been tweaked a little bit. You can use them for some lower education now. So, so not just college. Uh, let's say your kid goes to private school. Please note that you wanna do your research on this before, make sure that, that your you're make the right decision. And also you have a shorter time horizon if that's the case. So your investment decision should reflect that as well. So what are some of the downsides of 529 plans? Um, the biggest one is what happens if the beneficiary who is set up doesn't end up using the money. We're saving for my, uh, she's now three years old. Uh, and we're, we're saving for both my daughters, the three and a half year old, almost four year old. And the one year old, almost two year old. Well, what if they both say, Hey, we don't wanna go to college. Okay. Uh, we, we have this money saved up for you. What now? Um, you want to avoid just cashing the account out. So just saying, oh, we have this money. I'm gonna cash it out. Because if that's a case, you not only have to pay taxes, the federal, uh, income tax on that, which whatever your income is, you're paying income taxes on that money that you already paid income taxes on before on the growth of that to 10% penalty, that's a pretty hefty penalty, which is why you wanna avoid just cashing it out and saying, yeah, we're not using it for qualified education expenses. Now, if, your kid gets a full ride, you can or get some, uh, substantial scholarships you can apply to have the 10% penalty waived have of, you will have to pay taxes on the growth of that. Um, it, it loses it, its kind of quote, unquote Roth ability there. Now instead of pulling it out, what else can you do? Well, the 529 account can be transferred to an immediate family member of the beneficiary. So I touched on earlier the beneficiary, so somebody can set up a 529 account and the beneficiary can, can really be anyone and anybody can contribute on behalf of that beneficiary to that 529 account. However, if let's say you opened the 529 account for a friend's kid and uh, you're not expecting to have kids on your own or something. And that kid decides not only does he not want to go to school, doesn't need the money. You couldn't just say, oh, I'm gonna make my kid the beneficiary now of that account because they're not immediate family members. So an immediate family member, brother or sister is popular, right? One sibling decides not to go to school. You can apply the 529 account to the other one. Um, but it could even be a cousin only first only, it, does not apply to second cousins or maybe the parents decide to go back to school. Um, that's an immediate family member. You can apply it to, um, if the beneficiary is changed to an immediate family member, the same rules we discussed earlier now apply to that beneficiary. Overall. I think that the broad thing I want people take away from this is 529's are excellent, excellent tools in terms of battling the rising cost of college. You now can say I'm gonna invest this money today and for long term growth and hope it grows. Uh, but, but again, you have a long time horizon. So the, the science tells us in a well diversified low cost portfolio. It should grow over 10 plus years to help me battle that. And, and then not have to pay taxes on that growth is a pretty big benefit. Be cautious of over saving into them. Again, for some of the reasons we talked about, if, if the, the child decides not to go to school or, um, it's a full ride, something like that, then, uh, you might, you might be stuck with paying taxes on it and worst case scenario tax and a fee. So be cautious. Do your research, look at your state's plan first, then go back and look at, uh, all of the other options available to you and, and see what makes sense for you and your family. Um, but it's worth doing at an early age, uh, if you have children. So thank you so much for listening. I hope you all in joyed and we'll talk to you again in a couple weeks.