Finally, some good news: This year, the American economy could see its largest growth since 1946, according to a new report from Axios. In 2020, the economy shrank by 3.3% (if you're not savvy to economics, that's a lot) as the pandemic forced businesses to close, employees lost their jobs and even the employed slowed their spending while they were stuck at home. As vaccinations increase, businesses open and jobs return, financial experts expect a rapid upturn in the economy.
That upturn could also fuel rapid growth in the stock market. Since 529 college savings plans are based on investments in the stock market, this could be great news for parents. Right now, stocks are cheaper than usual and expected to grow faster than usual. So especially if you have a very young child, making a deposit into their 529 plan now could mean you get more bang for your buck than you will in the future.
Investing is confusing—so we've got answers for all of your 529 college savings plan questions.
How do 529 plans work?
There are two types of 529 plans: prepaid tuition plans and savings plans. "Prepaid plans let you prepay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges," says Brittney Castro, Mint Certified Financial Planner.
With prepaid tuition plans, the money you deposit grows based on the increasing cost of tuition. In 529 savings plans, the money you deposit is invested in the stock market—mainly mutual funds, in which money is invested by a professional manager (think Warren Buffett). Here, we're talking exclusively about 529 savings plans.
One cool feature of 529 savings plans is that you'll likely have an option for age-based investment allocations. That means when your child is young, the money will be put into higher-risk, higher-reward investments. As they get older and approach the point they'll need to use their savings, the manager transfers the money into progressively lower-risk investments to make sure as much money as possible is available when the time for college arrives.
Why is right now a good time to make a deposit?
Let's do a little math! Say that we know the following completely hypothetical things:
- You want to make a $1000 deposit into your child's 529 savings plan sometime in the next year.
- In 2021, 529 plans are expected to see a higher-than-average 5% rate of return (again, just for the sake of demonstration—no one knows exactly what it will be).
- In 2022, growth will slow down and the rate of return will go back to the usual 3%.
If that were the case, here's how your investment would play out if you invest now versus investing in a year:
A $20 difference over a year (or even a $51.50 difference over two) doesn't seem like much—but remember, that's money you didn't have to put in the account, and that will earn more money for you going forward. In general, the more you invest in a long-term college savings account and the earlier you invest it, the less you have to take out of your own pocket to help your child pay for college.
How do taxes work with 529 plans?
College savings plans are tax-sheltered, meaning when your child takes money out of their college savings account, it won't be taxed—as long as they're using it for education-related expenses like tuition, books, computers, room and board and even student loans (up to $10,000). Another benefit of 529 plans a lot of folks don't know about is that the original beneficiary (the child it's set up for) can transfer any remaining balance in their account to a family member, including their future children, tax-free.
If your child withdraws money for a non-educational purchase, they have to pay a 10% penalty no matter what state they're in, but some states then charge income tax on their withdrawal as well, while some don't. Maximum tax deductions for 529 contributions vary by state, too.
Can I get a 529 plan from another state?
Absolutely! You can invest in any 529 plan. Keep in mind you may lose some tax benefits by setting up an out-of-state plan—only a handful of states (Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana and Pennsylvania) allow residents to claim out-of-state 529 contributions on their taxes.
That being said, in some cases, it makes more sense to invest in another state's plan. For instance, if you live in a state that doesn't have personal income tax (like Texas or Washington), it doesn't really matter that you don't get tax benefits from out-of-state plans. As well, different plans perform better or worse than others (read that as "can make more money"), and have different fees. Even if you can get in-state tax benefits, it can still make more sense to choose an out-of-state plan that grows faster. Investment firm Morningstar releases an annual report that rates the best and worst of 529 plans and can help you decide what the best choice is for your family.
What should I look for when I'm comparing 529 college savings plans?
Castro recommends comparing a few different aspects of 529 plans. In addition to looking for plans that all state tax deductions or tax credits (if applicable), "In general, you should compare the fees associated with each 529 plan, as well as the investment options within the plan," she explained to Motherly.
"Another factor to consider is the ease of account access so you can fund and manage the account easily," Castro continued. "You can use free online comparison tools to easily compare 529 plans and assess what's right for you."
So for those taking notes, here's a list of questions to ask when you're looking at a 529 plan:
- Does this plan offer state tax deductions or tax credits?
- What are the fees associated with this plan?
- What investment options does this plan offer?
- Is it easy to access this plan?
- Is there an online management tool?
Can friends and family members contribute to 529 college savings accounts?
Yes! As long as they have your child's account number, anyone can deposit money into your child's college savings account. On the plan's website, look for a "Gift Contribution" option or just Google the plan name + gift contribution. There are typically options for both online and mail-in contributions. Now you know what to ask Grandma and Grandpa for on those tricky early birthdays!
Are there options for college savings other than 529 plans?
According to Castro, 529 plans have one significant advantage over other investment options.
"If you decide to go with another investment route like a brokerage account, you can still invest in the same areas, such as ETFs and index funds, but you will not get the tax advantages that a 529 plan offers," she says. "For example, with a 529 plan, investments within the account grow tax deferred and as long as the funds are used for the qualifying higher education expenses, they are tax free in the future. Some states even offer a tax deduction for the amount contributed to the plan."
Do ETFs and index funds have any advantages? Yes, Castro explains: "You have more options with a brokerage account since the money is not specifically for higher education and can technically be withdrawn at any time."
But other investment accounts come with a caveat. "Keep in mind that with a brokerage account, you need to be aware of the tax consequences such as capital gains or losses when you sell out of the investments," she said. That means that when your child withdraws money from a brokerage account, that withdrawal will be taxed.
However, that doesn't necessarily mean that it's a bad idea to invest in ETFs or index funds in your child's name, particularly in addition to investment in a 529 plan. Many financial experts recommend investing in long-term accounts like ETFs and index funds and not touching them until retirement. Many people don't start investing in these long-term accounts until adulthood, but having one in place for your child early on could set them up for more flexibility around college age and financial security much later in life.
Who should I talk to if I have more questions?
Castro says that the best kind of expert to go to for 529 and other investment questions is a certified financial planner. "Some financial planners work on an hourly basis and you can pay them for only a few hours of their time and get qualified advice to help you make the best decisions," she says. She recommends using the CFP Board search engine Let's Make a Plan to find a CFP in your area.If you want to get started setting aside money for college savings, Castro says, "You can also set up a college savings goal in an app like Mint to hold yourself accountable and begin a savings plan for the specific account you choose. Make sure to track your budget every month in Mint to ensure you are doing what it takes to reach this goal."