Financial planning Q&A: How to get the most out of your 529 plan

Where should I save for college?

529 college savings plans can help reduce the burden of education expenses by encouraging families to save and invest earlier, and by providing two key tax benefits. First, contributions are tax-deductible, or come with tax credits, in over 30 states (though not at the federal level). Second, 529 investment earnings grow tax-free and distributions aren’t taxed if they are used for qualified education expenses.

These tax benefits are an important feature, because their benefits compound over time. For example, let's look at a theoretical USD 10,000 contribution, invested for 20 years at a 5% annualized return. Invested in a 529 account, this approach would result in USD 26,500 that can go toward qualified education costs, 17% more than the USD 22,600 from a USD 10,000 investment in a taxable account subject to a 23.8% long-term capital gains tax at the end. In reality, this scenario likely understates the advantage of tax-free growth, because it doesn't account for any state deductions or credits for your contributions, or the tax drag from income and dividend taxes in your taxable account. This benefit could also grow larger in the future if capital gains tax rates go higher.

Which 529 distributions are “qualified”?
Surprisingly, according to IRS guidance , 529 college savings plans aren’t just for college. The general guidelines are tuition, fees, books, and room and board at eligible education institutions. Computer technology, equipment, or service costs can also qualify as long as they are used while the plan beneficiary is enrolled at the eligible education institution. Additionally, families can use up to USD 10,000 per year for tuition at elementary or secondary public, private, or religious schools.

Principal and interest payments toward qualified higher education loans are now also considered qualified 529 plan expenses, up to the lifetime limit of USD 10,000 per beneficiary and USD 10,000 for each beneficiary’s siblings.

However, the portion of student loan interest paid with 529 assets is not eligible for the student loan interest deduction. If you make nonqualified distributions from your 529 account, any gains in the account will be taxed as income, with an additional 10% penalty. Some states may also impose taxes or restrictions on certain distributions, so do consider your state’s policies.

How much do I need to save?
When it comes to estimating college costs and evaluating the amount you should save and invest, there are many variables to consider:

1. How many children will you send to college? Which type of school will each child attend? Will they receive a scholarship?
2. How much are we willing to cover for each child? What about graduate school?
3. Will you be eligible for financial aid?
4. How much will college cost in the future?

To answer question #4, we look at current college costs and estimate the rate of inflation. Based on Bureau of Labor Statistics data, the “sticker price” of college (tuition and fees, including room and board) has increased 4.9% annually, rising 294% in total since 1993. If we assume that tuition inflation continues at this pace, the projected cost of college in today’s dollars. These projected costs can be helpful when generally planning your college savings for a newborn, but as your children grow older you will have a clearer outlook on which type of program they're likely to attend, as costs may vary.

How should I invest my 529?
The 529 account’s asset allocation should be driven by the beneficiary’s goals and time horizon. Funds for a newborn’s college expenses have ample time to enjoy significant growth from an aggressive portfolio over the next two decades.

We generally recommend that funds needed in the next three to five years be removed from equity market risk, so that as a beneficiary enters high school, it makes sense to begin de-risking the portfolio by adopting a more balanced asset allocation.

That being said, it’s also important to coordinate your 529 plan with your overall financial plan and investment strategy. Investors who have saved very little for education outside the 529 plan will want to take on less risk in that part of their portfolio; for investors with ample room to make up for shortfalls with other assets, getting the most out of the tax-free growth is the primary goal, and the portfolio can take on more risk.

For answers to more questions on 529 plans, read the full blog How to get the most out of your 529 plan 11 May 2023.

Main contributors: Ainsley Carbone, Daniel J. Scansaroli, Justin Waring, and Katie Williams

This content is a product of the UBS Chief Investment Office.