Does It Make Sense to Start a 529 Plan Before Having Children?
A 529 plan is a special type of tax-advantaged account that helps investors save for college expenses.
Legally, 529 plans are known by the more consumer-friendly term, “qualified tuition plans.” The “529” name comes from the section of the Internal Revenue Code that established them.
529 plans are sponsored by states or educational agencies.
Traditionally, parents that already have children look into saving via 529 plans. But, do the plans still make sense if you don’t yet have any kids?
In many cases, the answer is “yes.”
Thanks to the flexibility built into 529 plans, they can make excellent savings vehicles. And there are definite benefits to starting early, even before you have any kids.
Here’s a look at the ins-and-outs of 529 plans, with a focus on the pros and cons for parents that do not yet have children.
529 Plans
There are two specific types of 529 plans, college savings plans, and prepaid tuition plans.
College Savings Plans vs. Prepaid Tuition Plans
Most investors are referring to college savings plans when they discuss 529 plans.
This is because prepaid tuition plans are simply accounts where you can “buy” the cost of a future education at today’s prices.
College savings plans are investment accounts that carry tax benefits for educational purposes.
These types of 529 plans are sponsored by states. This is in contrast to prepaid tuition plans, which are sponsored by private colleges and universities. Each state, including the District of Columbia, offers a college savings plan.
A college savings plan is something like an individual retirement account, in that you don’t pay taxes on your earnings while they remain in the account.
In addition to tax-free growth, the money you take out of a college savings plan for qualified higher education expenses is completely tax-free.
Qualified higher education expenses typically include tuition, educational fees, and room and board.
It’s worth noting that prepaid tuition plans, unlike college savings plans, do not cover room and board.
You can use money from a college savings plan at any qualified U.S. college or university. Sometimes, you can use the money for non-U.S. educational institutions as well.
Investment Options
You can choose from a wide range of options for investments in your college savings plan.
In most cases, investment options are similar to those you may already be familiar with in a 401(k) plan.
Typically, you’ll choose from a series of mutual funds or exchange-traded funds that are managed by well-known investment houses such as Fidelity or T. Rowe Price.
Most college savings plans offer principal-protected bank products as well.
Just like a 401(k) plan, you’re likely to find age-based portfolios in a 529 plan as well. These investments automatically grow more conservative in nature as a child approached the date when the funds are needed.
Performance can be compared at sites such as Savingforcollege.com, which compares similar investment portfolios across a wide range of providers.
Fees
As a 529 plan is a managed investment product, you should expect to pay some level of fees.
Some firms levy upfront sales charges or commissions.
You’ll also face annual management fees.
These fees can vary wildly from state to state, and from plan to plan.
As of 2018, a $10,000 investment in a 529 plan would cost you anywhere from $0 to $1,746 over a 10-year period.
Variations by State
Just because your state offers a college savings plan doesn’t mean that’s the one you have to select.
For the most part, you’re free to choose any 529 plan available, regardless of where you live, although some states do impose a residency requirement.
However, you may want to look at the 529 options in your state first.
Why? Because some states offer tax deductions to residents for in-state 529 contributions.
In fact, seven states offer tax deductions when you contribute to 529 plans in any state. So, you’re in a good position tax-wise if you live in:
- Arizona
- Arkansas
- Kansas
- Minnesota
- Missouri
- Montana
- Pennsylvania
On the other side of the coin, seven states also don’t offer any tax deductions at all, even though they impose a state income tax on residents.
Those states are:
- California
- Delaware
- Hawaii
- Kentucky
- Maine
- New Jersey
- North Carolina
529 Plan Rules
Anyone who is age 18 or older can open a 529 account.
Upon opening, you must select a beneficiary with a Social Security number for the account.
How is this possible if you plan on opening a 529 before you have a child?
Thanks to the built-in flexibility of 529 plans, it’s easy.
The owner of the 529 account can choose any beneficiary they want, and this beneficiary can be changed at any time.
This means you can name anyone you’d like to be the beneficiary of your 529 plan, even yourself.
Once your child is born and has a Social Security number, you can simply switch the beneficiary designation to your child.
Contributions
There are no income limitations as to who can contribute to a 529 plan.
However, there are maximum contribution limits.
The maximum contribution is established by each state. Typically, the maximum is in the $250,000 to $500,000 range.
But you can’t just dump all that money into a 529 plan at once. If you do, you might trigger the federal gift tax.
Gift Tax
Federal gift tax limits the amount of money you can give to any one person in a single year. For 2020 and 2021, that limit is $15,000.
However, college savings plans have two provisos that allow you to ramp up your contributions significantly.
For starters, if you’re married, both you and your spouse can contribute up to the maximum.
This means that in 2020, you and your spouse can gift a total of $30,000 to any single individual.
Additionally, college savings plans allow you to front-load up to five years of contributions.
This means that if you’re married, you can contribute a total of $150,000 to a 529 plan in the first year.
Note that if you do take advantage of this special five-year election, you’ll have to file Form 709 with the IRS.
Income Taxes and Penalties
If used for anything other than qualified educational expenses, 529 earnings are fully taxable as ordinary income.
You can avoid tax on the principal that you withdraw from the account, but not on the earnings.
Additionally, all money that comes out in excess of qualified higher education expenses faces a 10 percent penalty, including your principal.
Even if you take out 529 money for educational expenses, it can’t exceed the actual amount of QHEE you incurred during the year. If it does, it’s subject to taxes and penalties.
Pros
The pros of a 529 plan are apparent.
Being able to grow money on a tax-free basis for educational purposes means you can keep more of the money you earn from your savings.
If you live in a state that gives you a tax deduction as well, it means even more of your money goes to work right away.
As far as starting a 529 plan before you even have a child, there are also clear benefits.
The longer you invest, the more you can enjoy the power of compounding.
If you invest just $10,000 into your 529 account and earn 7 percent interest, you’ll end up with $19,671 after 10 years.
However, if you can keep that money in for an additional 10 years, you’ll end up with a balance of $38,696.
Without adding any additional money, you’ll end up with nearly twice the amount in your account if you can start an additional 10 years earlier.
If you can contribute more money over those additional 10 years, your balance could go even higher.
The bottom line is that the earlier you can start your 529 account, the better, at least when it comes to maximizing your final value.
Cons
The main negative of a 529 plan is that you won’t get a federal tax deduction for your contributions.
However, this is true regardless of when you start.
If you start a 529 plan before you have children, you run the risk that you end up not having any children, or not having any children that end up going to college.
In that case, you’ll have to either name a new beneficiary or take the money out for non-educational purposes, thereby triggering taxes and penalties.
Take Care of Yourself First
It’s admirable if you want to start saving for your child’s college education before they are even born.
However, financial experts will usually suggest that you put yourself on sound financial footing first.
An emergency fund is a real-life necessity for most Americans. Yet, nearly half of Americans don’t have enough in liquid savings to cover a $400 emergency.
If you start a 529 plan before you have an emergency fund, you might be forced to withdraw from it for unforeseen expenses. This can prove costly in terms of taxes and penalties.
After establishing an emergency fund, make sure that your own retirement planning is underway.
Set up regular 401(k) or IRA contributions and have them automatically taken out of your paycheck or bank account.
Once you’ve built up a margin of safety, you can consider investing in a 529 plan.
Conclusion
A 529 plan can be a great way to save and invest for college.
As with any investment product, you should shop around to make sure you’re getting the best deal.
When it comes to college savings plans, the “best deal” should include everything from state tax benefits to investment performance and fees.
If you’re planning to invest before your child is even born, make sure your financial house is in order first.
Remember that you can change the beneficiary of your 529 plan at any time, so if end up not having children that attend college, you can still allocate that money to someone else.
