College Savings Plan Options: 529s or Taxable Accounts?

Brynne Conroy

what is a 529

Have a kid? Odds are, you’ve thought about saving for college. You might not have followed through yet, but you know it’s something you should do.

And it really is something you should do—even if it’s only in small amounts. Research from Washington University in St. Louis shows that saving even just $1-$499 if you are low- or moderate-income triples the chances that your child will enroll in college, and multiples the odds of your child graduating college 4.5 times. If you save over $500, your child is 5 times more likely to graduate from post-secondary.

As you’ve considered saving, you’ve undoubtedly heard of 529 plans. These are tax-advantaged investment vehicles which allow you to save for college in various ways, depending on your risk tolerance and your state’s investment options.

But what if you’re not sure if your child is going to college? And what if the investment options in your state’s 529 plan aren’t that spectacular?

Know Your 529s

Nannette Kamien of Inspiration Financial Planning stresses that you must familiarize yourself with the different types of 529 plans: savings plans and prepaid tuition plans.

Savings plans allow you to simply invest for your child’s future educational expenses. They can use the money at any school, and you’ll reap tax benefits like not paying interest on your investments’ gains.

Prepaid tuition plans are very different. Essentially, you pay today’s in-state tuition prices for future credits. Let’s say a credit hour today cost $800. In the future, that number will almost inevitably be higher. By purchasing now—at today’s rates—you’re saving a ton of money over the long-term.

There is a caveat, though: your child must go to a state school to use the money. Kamien says that these plans often have an opt-out option where you can take your money plus a moderate amount of interest and use it at a college outside your state’s school system, but the interest is almost always pales in comparison to the return you would have gotten by investing in a 529 savings plan.

Look to Other States

If you’re looking at your state’s 529 investment options and aren’t thrilled, there are steps you can take before opening a taxable investment account where you have more freedom.

“Every state has at least one 529 plan,” says Kamien, noting that many plans allow you to enroll across state lines. “There are lots of different investment options. Utah’s plan has access to Dimensional Fund Advisors investments. A lot of people like the way they look at investing. There are also accounts with options for Vanguard ETFs and other low-cost investments.”

What if my child doesn’t go to college?

If, after all your saving, your child doesn’t go to college or gets scholarships to fund the entire thing, your efforts have not necessarily been in vain. You can use the money you’ve saved for things like off-campus housing, books and supplies like technology required for courses, and internet service. If your child doesn’t go to a traditional, four-year school, the money can also be used for vocational or trade school.

Kamien notes that with the passage of the recent tax bill, up to $10,000 in withdrawals per year can be used for K-12 tuition at private schools, as well—which may be particularly helpful if you follow the next step.

My Kid Doesn’t Have Any of Those Expenses

If your child truly can’t use their 529, you don’t necessarily have to give it up. You can transfer it to another family member. If you have a younger child at home, even if they aren’t college-bound you can start spending down your 529 while they’re still in primary or secondary school if you’ve opted to send them to a private institution.

It’s also important to remember that while your child may not be pursuing their education today, they may change their mind and return to the halls of scholarship sometime in their adult life. The number of nontraditional students in America has skyrocketed over the past several years, and one day your child may be one of them.

The worst-case scenario is you make a withdrawal. You can withdraw your principal investment at any time, but when you withdraw interest, you’ll have to pay a 10% penalty on top of taxes and fees. If you had a taxable investment account, you’d only have to pay the taxes and be able to skip the 10% penalty.

Taxable Accounts vs 529s

While every individual’s situation is different Kamien generally recommends 529s over taxable investment accounts. You can take out the principal at any time without fees or penalties when you save in a 529, which keeps your money more liquid should you need to allocate it somewhere else. On top of that, if you’re using an advisor to invest in a taxable account, their fees are likely to be higher than the ones you’ll find in the 529.

If you do choose to go the taxable account route, though, Kamien cautions to put the account in your name—not the child’s. When you invest in a taxable account in your child’s name, it is known as a custodial account.

“When they go to fill out the FAFSA, custodial accounts are heavily weighted in the financial aid calculation,” explains Kamien. If the taxable account is in your name, it will still count, but it is not weighted as heavily. “You also need to remember that when your child hits the age of majority--18 or 21 depending on your state—that money is no longer yours. It’s your child’s. Will your kid be responsible with all the money you’ve saved for them? Sometimes 18-year-olds are not.”