Pros and Cons of Section 529 Plans: A Look at the Benefits

If you discover anything in your research about Section 529 plans, it's probably that there's no such thing as a simple answer and that sometimes these plans won't suit your needs at all. A 529 plan also isn't for you if your income is very low and you pay tax at the lowest rates, because your student will probably receive full grants. Likewise, if your student is going to give Einstein a run for his money, he may receive a free (or partially assisted) ride to some fabulous institution and won't need the full amount of your savings.

In Voltaire's Candide, Dr. Pangloss is forever talking about "the best of all possible worlds." Well, in the best of all possible worlds, 529 plans are a wonderful, marvelous creation that can pay all qualified postsecondary educational bills (and may even cure the common cold if invested correctly). In any number of scenarios, if you pick the right plan and the right investment strategy for your student, you and your student win. It's as simple as that.

Higher Returns Than Traditional Savings And Investment accounts

Saving money is the name of the game, but saving efficiently (and accepting help when offered) is the best way to go about it. Although the federal and state governments won't actually start a savings account for you or put money into one that you've opened, they do provide tools to help your savings grow.

Section 529 plans offer three ways by which your savings can grow faster than they would if you invested them in an ordinary investment account or in your local savings bank:

• Tax deferrals (postponing when you pay tax)
• Tax exemptions (not paying any income tax at all on earnings)
• State income tax deductions (sometimes being able to exclude your contributions from your income in the year that you make the contributions)

Here's how it works. George and Hannah, who are Maryland residents, have a baby in 2003. They don't have any savings in the bank, only the money that they currently earn, so they know that paying college costs 18 years down the road may be tough. George and Hannah think it's wise to start planning now.

They do their research and begin implementing their decisions as soon as the baby arrives. Their first decision is to open a Section 529 plan, and their second is to opt for four years of paid tuition in Maryland's prepaid tuition plan, which offers not only tax-free qualified distributions but also tax-free contributions. They both attended the University of Maryland, and they feel they received a fine education. It seems like a good choice for their baby.

George and Hannah know that the next 18 years are going to pass quickly and that their son will be heading off to the University of Maryland (or any other college or university, but they're loyal alumni, so Maryland seems the obvious choice) in 2020. By religiously making their payments into the plan, they know they'll have four years' worth of tuition credits when the time comes. They expect that their son, who they expect will be a motivated student, will complete his degree in four years, graduate, and start his working life with a reasonable job in a reasonable company.

Although the tuition will be the same, whether or not Hannah and George have a Section 529 plan, the amount of money they have to supply will not. Even if they fund a savings account with exactly the same amount of money as they fund an equivalent 529 plan, they'll have to pay federal and state income tax annually on income being earned. In addition, although no federal income tax deduction is allowed for contributions made into a 529 plan, Maryland provides one (as do many other states). In fact, if Hannah and George put their money into a traditional savings or investment account, they may pay more in tax in the years leading up to college than they would have if they'd funded a 529 prepaid tuition plan.

This example uses fairly generous rates of investment return and relatively moderate rates of tuition increase. Real life rarely follows planned examples exactly. If you're not using a Section 529 payment plan, you may need to adjust your budget and your savings accordingly.

Figure 7-2 illustrates how your money may grow in a 529 plan and how the same amount of periodic savings (whether you use weekly, monthly, or quarterly deposits) will cost you more if you put it into conventional investments outside of a 529 plan. As in Figure 7-1, which shows how the numbers work if you save the same amount each month, all numbers assume a 5 percent annual rate of return, and federal income taxes are calculated at 25 percent. No adjustment is made for state income tax (each state is individual in this regard), and most savings plans don't carry residency restrictions.

Figure 7-2 clearly shows that, over time, you'll save much more money if you don't pay tax currently on your earnings. If you live in a state that has a state income tax on investment income but that follows the Section 529 federal rules, the disparity between the Section 529 funds and the ordinary investment funds becomes even greater. Regardless of what your total rate of return is (and no one has any accurate idea what it will be until it's actually earned, although it could be much higher or lower, depending on market conditions and how aggressively you invest), saving money costs you less when you can save in a tax-deferred or tax-exempt account.