The plans allow you to contribute money to an investment account, and then withdraw the funds once your child goes to college. These funds can be invested in a number of mutual funds, exchange-traded funds and principal-protected bank products.
The main reason to choose a 529 versus a regular brokerage account is the tax benefits. These benefits vary from state to state. Overall, though, you can deduct contributions from your state income tax or matching grants, according to the Securities and Exchange Commission. Once you withdraw money from the account, and if (and only if) the money is used for qualified educational expenses, earnings in the 529 account are not subject to federal income tax or, in many states, state income tax.
Another main benefit is that tax-free earnings grow over time within the account. “The longer your money is invested, the more time it has to grow and the greater your tax benefits,” the SEC states.
The biggest gripe among investors over 529 plans is that you’ll pay penalties if the money is not used for qualified educational costs such as tuition, room and board and various school supplies. If you withdraw the money for other reasons, the money will be subject to normal tax and a 10% penalty.
One reason for the penalty is that the tax privileges given to the account are unique. It is the only investment vehicle of its kind that can be grown, deducted and withdrawn tax free. However, there are limits — Currently, the lowest limit is $235,000 per child, and up to $500,000 in some states.
Normally, the account owner would have to pay long-term capital gains taxes or taxes on withdrawals of invested funds.
How Is This Allowed?
While it seems almost too good to be true, the government is incentivized to allow the special treatment of these funds. Any money given personally and over a long period of time by citizens is money the government won’t need to loan out in the future, in the form of student loans.
Criticisms and Things to Consider
Despite its similarities to a savings account, a 529 plan is still investment account, and as such, has fees associated with its management. A recent Morningstar report found that the management fees associated with a 529 are higher than fees for traditional mutual funds. Of course, the biggest one is the penalty you’ll pay should your child decide not to pursue higher education. In that case, the money becomes subject to tax.
For these reasons, some choose to invest in a Roth individual retirement account for their children instead of a 529 plan, but that is another conversation entirely. As always, these are all complex investment products that are best discussed with a financial advisor.
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