What the heck is a 529?
Actually, there are two kinds: a 529 prepaid tuition plan, and a 529 college savings plan. I’m going to spend this post talking about college savings plans, but if you’d like to hear about a prepaid tuition, sound off in the comments section.
In a nutshell: a 529 college savings plan is a tax-advantaged investment account, similar to an IRA or a 401(k); you contribute money to specific mutual funds in the plan, and you get a tax break on the investment returns if you only withdraw it for qualified college expenses — withdrawals for other purposes are penalized. To break it down further:
Tax-advantaged: specifically, while the money you put in is not deductible (as opposed to (generally) money you put into a traditional IRA), the money grows tax-free until you withdraw it. (Also, if your state has income tax, contributions to that state’s 529 plan are generally state-tax-deductible — not that Texans have to worry about that kind of thing.)
Specific mutual funds: like a 401(k) and unlike an IRA, there are very specific mutual funds you can choose from. Which funds these are depends on the 529 plan in question. There’s almost always an “autopilot” option that gradually shifts the investments towards more stable securities (i.e. from stocks to bonds to cash) as your child approaches matriculation.
Qualified college expenses: Tuition, room and board (if you’re enrolled at least part time), and computers, books, etc. that are required by the institution. However, it is possible to transfer beneficiaries of a 529 plan; in other words, if your child decides not to go to college, you can switch it to any cover direct relative, including siblings, cousins, in-laws, or step-siblings.
Penalized: In addition to being taxed on the earnings, you’ll take an additional 10% tax penalty on those earnings.
Why would I want one?
Because the tax benefits put money in your pocket, especially if you invest for a long time and contribute a large amount. To give an oversimplified example, if you put $34,000 into a 529 and let it sit for 18 years, during which it happened to earn 5% each year, by the end you would have about $82,000 (which, incidentally, is what it takes to send your child to Texas A&M for four years nowadays). However, if that same money were sitting in a standard investment account, you would have to pay 15% (assuming it was all long-term capital gains) of the gains to the taxman, leaving you with not quite $75,000. (Again, a state income tax would knock that down even further.)
Which 529 plan should I pick?
If your state has income tax, the choice is generally pretty easy — you pick your state’s plan. However, in cases like Texas, there’s no reason not to take your pick of any of the 529 plans out there. There are generally two factors that come into play: how expensive the 529 plan is, and what its selection of mutual funds is. Given the power of low-cost index funds (not to mention mutual fund companies owned by the funds themselves) my favorites are Utah, Nevada, and Illinois’ Vanguard plans.
Update 6/24/2013: Utah’s UESP recently added several funds to their lineup that, in my opinion, push them well over the top. They now have nearly every interesting asset class available, including every combination of large/small/international v. value/growth, plus REIT’s and short-term bonds. Moreover, they’ve added options from Dimensional Fund Advisors — in my opinion the only fund provider who might actually beat out Vanguard — making them one of only two 529 plans to do so.
OK, I trust you, but can I get a second opinion?
Anything else you want to know? Operators are standing by! (Well, the comments section is, anyway.)