College 529 Savings Plans: How to Get the Most Out of Them

Editor’s note: This is part three of a three-part series about college 529 savings plans. Part one is When Choosing Funds for Your College 529 Plan, Don’t Make This Mistake, and part two is What You Need to Know about College 529 Savings Plans.

School is back in session, much to the relief of parents nationwide. And in the spirit of back-to-school, now is a good time to review how to save for college and, in particular, the 529 college savings plan. After all, college isn’t cheap, and parents will need to squeeze the most out of their savings plan if they hope to have enough saved. Here to help are a few ways I advise my clients on how to get the most out of their 529 plans.

What Is a 529 Plan?

Hands down, the 529 plan is a great way to save for college. The tax benefits are key. With a 529 plan, you pay no annual taxes on the investment gains inside the account, plus distributions for qualified expenses like tuition, certain fees and qualified room-and-board expenses are tax-free.

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A relatively new provision allows account owners to withdraw $10,000 a year per student for private primary or secondary education.

Each state administers its own plan, and you are free to use any state’s plan. However, some states offer a state-tax deduction if you are a resident and use its in-state plan. That’s the basics, there is much more to know, but today I want to focus on five ways parents can maximize their 529 plan.

The Time Horizon Is Not Freshman Year

Parents of teenagers often ask me if they should open a 529. They wonder if it makes sense given how close the child may be to needing the money for college. While there are a variety of factors to consider, I remind parents the time horizon for needing the money for college is not freshman year, but by senior year. So, for instance, a parent with a 13-year-old may think they have only four years till they’ll need the 529 money, when in reality the time horizon could be eight years, since not all the money is withdrawn in the freshman year. If that is the case, then yes, eight years may still be enough time to invest in a 529. (There may be some financial aid considerations.)

Having said that, I probably wouldn’t invest all the 529 money in equity mutual funds, given the time horizon is only eight years — that is too risky. But perhaps the tuition payment earmarked for the eighth year, or senior year, could be invested in a dividend-paying mutual fund or a balanced mutual fund, since that has the longest time horizon. I suggest consulting with a qualified financial adviser who can help ensure your investment mix is aligned properly with your risk tolerance and time horizon.

Your State’s Plan May Not Be the Best Plan

Some states offer a state income tax deduction on your contributions, assuming you are a resident of the state. Other states have upped the ante even more, with some offering matching contributions. Always check your state’s offerings and incentives before opening a 529 account.

Keep in mind, you are not limited to your home state’s option. A parent in Connecticut can use California’s plan and vice versa. The downside in this example is the Connecticut parent does not receive a tax deduction for contributing to a California 529 plan.

Why would anyone not use their home state’s plan and forgo the state tax deduction? Mutual fund choices and fees. If the mutual fund choices in your home state’s plan are lousy or expensive, that probably won’t help the account grow. There are several websites to compare 529 plans, or a financial adviser should know what to look for as far as fees and investment selection. The point is don’t take it for granted your state’s plan is the best option.

A Compromise: Use More Than One 529 Plan

If you still want to use your home state’s plan to get the state income tax deduction, but want better mutual funds, you may want to try using your state’s plan up to the state tax deduction cap – usually $10,000 a year for married parents – and a separate 529 somewhere else for any additional money.

I see this in states that cap the tax deduction to the first $10,000 of contributions. The next penny over the cap is not state tax deductible. A parent then can contribute the first $10,000 to the home state’s plan for the deduction and use another state’s plan for anything above the cap. This may help with diversification, or using a different plan may have more and better fund choices. You want to be mindful of the annual contribution limits.

The downside is the administrative burden, do you really have the time to oversee two different accounts for each child?

Get the Grandparents Involved

A recent rule change on the FAFSA is helpful for grandparents who want to use a 529 for a grandchild’s education. Prior to the rule change that took effect Oct. 1, 2022, distributions from a grandparent’s 529 were counted as untaxed income to the student and could reduce the student’s aid eligibility. Starting with this year’s FAFSA, for the 2023-2024 school year, a grandchild does not have to report a distribution that was taken from a grandparent’s 529. That’s a big change and should prompt more grandparents to use 529 plans.

Keep in mind, the CSS Profile – a financial aid form used by many colleges to calculate their own financial need – still considers a grandparent’s 529 as a countable asset. However, I’m not sure that should deter grandparents from wanting to use 529 plans, as not all colleges use the CSS. Either way, I believe the more hands that can help fill the piggy bank for college, the better, and with the holidays coming up, this could be a good time to talk to Grandma about 529s.

Paying Private K-12 With a 529 Plan

Parents can use up to $10,000 a year from their 529 plan to pay for private K-12 tuition. If you are paying for private school out of a cash or checking account, you may want to consider first routing the payment to the 529 for the state tax deduction. This is a good idea for parents who are already contributing to a 529 plan but not up to the amount for the state tax deduction — they’d have more room to contribute.

For example, if a family is contributing $5,000 a year to their state’s 529 plan, but the state tax deduction is up to $10,000 in annual contributions, they can contribute the additional K-12 tuition payment to the 529 plan to get them to the $10,000 cap. (The $10,000 cap is an example — each state’s rules vary.) This assumes your state offers a state tax deduction for contributions, your state considers K-12 tuition a qualified expense, and there is no minimum waiting period for withdraws. It’s best to check with the 529 administrator first.

There may be some drawbacks to this approach. Namely, it can be a hassle to move money around. Also, it could lead to commingling college funds and K-12 money, which should be invested differently, given their different time horizons, but this trick could also save you a few bucks on your state taxes.

The Right 529 Plan

When considering a new 529 account, I always look for a plan with a strong mutual fund lineup and competitive fees. A good 529 plan will have a wide selection of different mutual fund investment objectives, like growth, value, large and small companies, domestic and international and various fixed income choices, like a preservation portfolio or government bond offering. This can help with diversification. Even if you use a target date fund, which picks the mutual funds for you, diversification is key in my opinion.

Beyond that, the underlying mix of stocks and bonds — your asset allocation — is key to the performance of the account. You don’t want to be too conservative with a young child’s account — the account might not grow enough to outpace the rising cost of college. Parents of younger children may want to be more growth-oriented, whereas those within a few years of needing the money should scale back the risk.

Keep an eye on mutual fund expense ratios, too, that can eat into your return. I sometimes will recommend a client use the large-cap index mutual fund if their 529 has one, then sprinkle in more active managers where I find it may make more sense. I will use an active manager within the 529 if I like the track record and/or use it to complement the index fund. Using index mutual funds within the 529 can help keep the costs down.

Parting Thoughts

The 529 plan is a great way to save for college, grad school and K-12 education expenses. Beyond what I mention here, the best piece of advice I can give new parents is to start early and automate your savings. Starting early can help your investment grow over time, while automating your savings — having some of your paycheck go directly into the 529 each pay period — takes the guesswork out of savings because it’s done for you.

The rest of what I offer here can help enhance the 529 plan and maximize your college savings plan, which, based on the current cost of a four-year college education, is something I think we can all agree is a good thing.

The author is a Certified Financial Planner with over 22 years of experience in helping clients make smarter better financial choices. For more information, please visit www.michaelaloi.com or email maloi@sfr1.com.

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