529s Are Still the Best Way to Save for College
With graduation season winding down, now may be a good time to refocus attention towards those who are earlier in the process, the ones saving for the ever-increasing cost of higher education.
According to the Education Data Initiative, the average annual cost for public in-state, four-year institutions is $25,707; the cost for out-of-state students who attend public colleges is $44,014; and four-year private colleges come in at an average of $54,501 per year.
Although many families are not paying the full sticker price, they still try to squirrel away some money to help defray future costs.
For these folks, I continue to recommended the 529 Plan, and for the record, I did so BEFORE the advent of 5-29 Day (get it, May 29 is 5/29!), a prompt that states use to highlight participation in 529 education savings programs with various incentives.
As a primer, as state and federal money for higher education dried up in the 1980s and ’90s, the onus was on families to absorb higher costs for funding education. In 1996, there was a bipartisan effort to provide federal tax benefits for college savings plans, which resulted in the creation of Section 529 of the Internal Revenue Code (IRC).
Today, 529 plans are sponsored by states, state agencies, or educational institutions and usually come in the form of prepaid tuition plans or accounts where savers can invest for future qualified higher education expenses.
The earnings in 529 accounts are not subject to federal income tax and, in most cases, state income tax. Additionally, some states offer residents of the state specific incentives, like the ability to deduct contributions from state income tax or a matching grant. When the funds are withdrawn to cover qualified expenses, there is no tax due, at all!
There have been some big changes to the 529 plan since its inception. In 2018, after the Tax Cut and Jobs Act was enacted, plan owners could withdraw up to $10,000 per year saved in 529 plans to pay for public, private, or religious elementary or secondary school, free of federal taxation. Some states that offered state tax deductions require that deduction to be clawed back if used for anything other than post-secondary education.
The other big rule change occurred at the end of last year and addresses the concern that unused 529 plan funds would be subject to state and federal income taxes and an additional 10% federal tax penalty on earnings.
In the SECURE 2.0 Act of 2022, unused 529 funds can find a new home in a Roth IRA account for the beneficiary of the 529 plan, without any taxes or penalties. The new rule takes effect in 2024 and there are some basic requirements to know before you get started with any transfers:
The 529 account must have existed for at least 15 years.
The lifetime maximum a 529 beneficiary can transfer under the rule is $35,000.
No contributions or earnings on contributions from the last five years can be transferred to the Roth.
Transfers are subject to annual Roth IRA contribution limits, which are adjusted from time to time for inflation, the 2023 limit is $6,500. Unlike contributory Roth IRAs, there is no income limit to using this enhanced 529 to Roth transfer.
With these changes, the 529 plan remains the best option to fund college, presuming that you have addressed the core issues in your financial life. As a reminder, that means that you should have an emergency reserve fund that can cover 6-12 months of expenses, you have paid down your high interest debt (credit card, auto loan, student loan), and you are maximizing your retirement plan contributions.