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Why use the 529 plans to save for college

by retirebyforty on October 23, 2013 · 44 comments

in expenditure, goals and milestones, saving

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Here is a scary statistic – The class of 2013 graduated with an average of $35,200 in college related debt. OK, that’s a bit better than I thought. I have heard even worse stories of kids who owe much more than that and are unemployed. My brother owed over $100,000 when he graduated and it’s hard to get going when you start out in a hole. (He’s a doctor though so I’m sure he’s doing fine.) My parents paid for my college education and we really want to do the same for RB40 Jr. That will be our legacy to him as we are not planning to leave much if any inheritance. I think the best gift you can give your child is a good education.

529 saving plans college cost pros cons

An alternative is to live at home and go to Portland State University (right next door) for 2 years and then transfer.

How much college will cost

Oh man, this is going to be a shocker to all the parents who haven’t looked into this yet. According to the College Board, the cost of higher education has been rising at about 6% annually. College is already expensive and 6% increase per year is kicking it into the stratosphere.

We’ll use savingforcollege.com’s online college cost calculator.

The following are needed to get started. .

  • How old is your child? 2 years old
  • Will be attending a college that currently costs $32,000 annually.  I’m using the current instate cost from our alma mater, UCSB. You can look up your kid’s future college at the National Center for Education Statistic.
  • Will attend college for 4 years on a full time basis.

Here is the result

100% of your total college costs will be $355,618.

Yikes! That’s more than what our home is worth. We already started saving for his education, but I’m not sure if we can reach that amount in 16 years.

What is the 529 plan?

One way to save for college is through the tax-advantaged 529 plan. Each state has a different 529 plan and you can invest in any state’s plan. There are two types of 529 plans, prepaid and savings plan. The prepaid plans allow you to pay tuition at the current price and attend in the future. The saving plans invest in stock and bond funds. I don’t really like the prepaid plans because we have no idea where the kid will eventually ends up. The saving plan is much more flexible.

Pros of 529 plans

As mentioned above, there are tax advantages if you invest in the 529 plans.

State tax benefit – Many states provide state income tax deduction for the contribution (up to $4,455 by a married Oregonian couple filing jointly.) That’s 9 to 10% tax deduction for us. You can check your state’s 529 tax benefit here.

Federal tax benefit – The distribution for the beneficiary’s college costs are tax free. Assuming the government doesn’t change the law.

Automatic option – You can set up automatic deduction so you don’t have to worry about it. Many states have age-based funds which will allocate your fund according to when the beneficiary turns 18 and is expected to enter college.

Transferable – If RB40 Jr. declines to go to college, then we can transfer that fund to other qualified members in our family. Perhaps Mrs. RB40 can finally work on her Ph.D.

Estate plan – This one is for the grandparents out there who want to help out. They can contribute up to $14,000 ($28,000 for married couples) per beneficiary tax free every year. This is a great way to pass money down to future generations without paying taxes while retaining control of the fund.

Financial aid calculation – 529 saving accounts in your name is treated as the parent’s asset. This is good news because only 5.6 percent (or less) of the 529 is used in the expected contribution toward your child’s college cost. Student’s assets are computed at 20% in the financial aid formula.

Disclaimer: Talk to your tax professional when you withdraw or contribute a large amount to make sure you don’t run into any unexpected problems.

Cons of 529

Limited investments – Generally, there is only a few investment choices in the 529 plan. The Oregon plan has U.S. equity, International Equity, Social Choice (socially-conscious funds – seem very Portlandia from the name), inflation-linked Bond, Bond Index, and Money Market. We can also use the age-based portfolios and target allocation portfolios.

Reallocate once a year – You can only reallocate once per year in the 529 plan.

Penalty – The earning portion of money withdrawn from the 529 that is not spent on college expenses will be taxed at the normal rate, an additional 10% federal tax penalty will be assessed, and there is the possible recapture of any state tax deduction. An exception to the 10% penalty can be claimed if the beneficiary has passed away or if the fund is not needed because he has received a scholarship.

529 college saving plans are a great way to save

Generally, I think everyone should max out their retirement contribution first and then contribute to the 529. Your 401(k) and Roth IRA provide great tax benefits and you may not have to pay the 10% early withdrawal penalty if you take money out to pay for college.

I also think it’s a good idea to front load the 529 to maximize the compound benefit. If you put in $70,000 early on, it will earn much more than if you spread it out over 18 years. The earnings will be tax free so it’s best to get rolling ASAP. The earlier you invest, the longer your fund has to compound.

  • If you save $70,000 when your kid is born, you’ll accumulate $294,040 (assuming 8% annual gain.) That’s $224,000 tax free!
  • If you spread it out over 18 years and save $324/month until your kid is 18, then you’ll have $156,585. It’s still good, but probably won’t be enough to pay for 4 years of college.

The only caveat is to make sure not to go over the $14,000/year gift limit. For the 529, you can contribute $70,000 in one year and treat it as if you were contributing the lump sum over five years.

Unfortunately, we don’t have $70,000 sitting around. We are planning to contribute about $10,000 per year until he’s 5, and then step down a bit after that. Currently we have a little over $30,000 in the 529 with 16 years left to go.

Our goal is to pay for 4 years of instate public college. If he wants to go to graduate school or attend a private college, then he will probably have to take out some loans.

*Tax shield – One reader mentioned that 529s could be valuable as tax shields even without any intention of using them to pay for education. I can’t find any way to do this (without paying the penalty) from my research. If you know some way to do this, please share.

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{ 44 comments… read them below or add one }

Clarrise @ Make Money Your Way October 23, 2013 at 12:41 am

This is scary but this is the fact. Right now my goal is to save more for my daughter’s future.

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retirebyforty October 23, 2013 at 6:20 am

Good luck! We are saving as much as we can early on too.

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Andy @ theFIREstarter.co.uk October 23, 2013 at 2:10 am

This is very interesting! You seem to have a lot more options for tax shielding various investment accounts than we do over here in the UK, it’s good to see and I wonder if we’ll have something similar in a few years time with higher education costs also rocketing through the roof. (http://www.thisismoney.co.uk/money/studentfinance/article-2188668/Student-debts-escalate-average-cost-years-university-soars-53-000.html – yikes!). I managed to escape with about a £10k student loan and a couple of overdrafts I think.

I’m sure it’s been mentioned many a times on these sort of articles as well but if there are any “kids” reading you really should consider whether it’s worth actually forking out for University/College in the first place. I did Music Technology with dreams of becoming an international star DJ (doesn’t everyone? :) ) and now do not work with anything to do with the music industry. With a lot of courses such as that one, if you really want to work in those sorts of areas, you are probably better off using those 3 years to get your foot in the door somewhere even if it means working for peanuts, getting to know people, and getting valuable experience and working your way up. For many other careers though higher education is the obvious (and only) way to go.

Just my two pence/cents :)

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retirebyforty October 23, 2013 at 6:22 am

Great job escaping with a reasonable amount!
I also think it’s better to work for certain fields. I don’t know if I’d pay for a Music Technology degree. :)
Thanks for dropping by.

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Daddy Domestic October 23, 2013 at 4:04 am

Good conversation starter Joe. My wife and I just had a philosophical discussion on whether or not we should commit to saving for our child’s college fund in a separate account. We didn’t reach a clear consensus, but there are definitely pros and cons. For instance, several of my friends went to college only because their parents had a lump sum for them to spend…..and accomplished nothing while goofing off for several years. I wonder if they would have been better served deciding what they wanted to go to college for, and having a little skin in the game. I wonder sometimes if college is pushed on too many people, and has become too available to the masses. Of course we wouldn’t want to base your decision on the million “what ifs”.

An alternative would be to invest in assets or businesses with increasing cash flow, and then help the kiddos if they decide to attend college. That way me and the Mrs. DD could help them, and ourselves in retirement, no matter what life throws your way. I don’t know that I’m better off because I got my engineering degree and I would have gone either way because of the scholarships, but I don’t see this as a clear cut decision.

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retirebyforty October 23, 2013 at 6:26 am

If the kid understand that the parents sacrificed to save for college, they would appreciate it more. I knew my parents worked really hard to send me to college and I tried my best. Of course, if our kid doesn’t want to go to college or picked an art major, we’ll probably keep the 529 invested. It can be used if he decided to go back to school or even for future generations.

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Holly@ClubThrifty October 23, 2013 at 6:53 am

We live in Indiana and our state gives a 20% tax credit on the first $5,000 we save in our kid’s 529 plans. So, it’s a pretty good deal to save at least up to 5K per year. We save monthly but not a ton for them because we’re also worried about saving for our own retirement.

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retirebyforty October 23, 2013 at 8:07 am

Oh wow, 20% is a great incentive. Retirement is higher priority for us too, but we’re lucky to be able to do both.

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Andrew@LivingRichCheaply October 23, 2013 at 7:00 am

We opened a 529 plan for Baby LRC but there is only a few hundred dollars in it. Interesting thought about front loading it. I’ll have to try, but it’s tough to come up with a large amount as we’re also looking into buying a place. The tax benefits are great and in NY, most of the funds are low cost Vanguard ones so I like the choices. Both my wife and I went to State Universities so I’m a big proponent of going to State U…so much more affordable!

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retirebyforty October 23, 2013 at 8:13 am

Good luck! We definitely need to help out as much as we can. Starting out with a big student loan debt is not good.

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Done by Forty October 23, 2013 at 7:40 am

Hey Joe,

Phoebe at All You Need Is Enough put in place a 529 plan recently, and I think we’ll follow her path: open a 529 in my name, invest, make a baby, then change the beneficiary to my future child. Do you see any problems with that plan? We’d like to get an early start if possible.

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retirebyforty October 23, 2013 at 8:15 am

I think that’s a great plan. We should have done that earlier, but we weren’t sure if we were going to have a kid or not. It’s great to get started early.

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Kids Almost Done with College October 23, 2013 at 8:21 am

We utilized the Private College 529 Plan for our two kids. We were very happy with the program and results. In short, the program has made arrangements with a decent number of private colleges/universities (I would guess about 100 or so) where you can pay for tuition (fractional shares) at today’s rates, and be guaranteed that your investment will cover the same amount of tuition in the future. For example, you can deposit $25,000 today, and thay may, for xample, cover a full year of tuition at school X, and 50% of tuition at school Y. When your kid is ready for college, you are guaranteed that regardless of the current cost, you will still get the same fraction of tuiton covered. (Assuming college costs increase at about 5-6% year, it is not a bad risk free return.) The particiapting schools range from smaller liberal arts colleges, to major research universities (e.g. Stanford, Vanderbilt), so there is a lot of choice, but you are restricted to the colleges in the plan. Also, your kid has to get into the school–the plan only covers costs, it makes no promises about your kids being able to actually gain admitance. There are no state tax deductions/credits available, but you do not (like all 529 plans) pay any taxes on the increase in the value of your investment. It worked for our two kids and us—might be worth a look for some of you with younger kids.

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retirebyforty October 23, 2013 at 11:13 pm

That’s a great idea. Tuition at private colleges are quite expensive. I just checked Stanford and it’s 42k/year now.
So this just covers tuition? You’ll have to for for housing, books, etc… by some other means, right?
I’ll talk with the missus and see what she thinks. Thanks for sharing.

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Kids Almost Done with College October 24, 2013 at 3:59 pm

Yes—just covers tuition and fees; you can supplement the Private College 529 plan with another 529 plan (perhaps the one sponsored by your state) to save for room and board, books, and other allowable educational expenses.

I would also add one other piece of info that I think is relevant. My kids were good students (not exceptional, but good), and gained admission to some of the better know universities in the plan—-Tulane and Emory are two that come to mind. The plan could be used at both of these schools. Neither school offered the kids any merit based aid. They also applied to some smaller lesser known schools (and both ultimately went to small liberal arts colleges). Because these schools have to compete for students who could otherwise enroll at larger, better known schools, they have to be more generous with merit based aid. In my kids case, both of them basically got scholarships worth half the price of tuition. My point is that some of the schools in the program are very generous with merit based aid—and added plus. If you save a few bucks while your kids are growing up, make sure the kids do their homework, get involved in a few extra curricular activities, don’t commit any felonies, etc. there is no reason why kids cannot go to a private college (if they so desire) without breaking the bank. Of course, there are many fine state universities that provide a lot of bang for the buck too.

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aB October 23, 2013 at 8:51 am

Canadian so, RESP (Registered Education Savings Plan), putting in $210 a month. Government matches 20% for first $2500 (up to $7200 or something). When taken out, the gains are taxed to the child (when he is in school, should have little income).

I agree education is important. For me, was thinking of just maxing the government grants, and top up the dividend account after that. Hopefully, that will cover both education when needed and retirement when needed.

Front loading sounds good, but that is also the time where the most money is needed (or at least the most change in money priorities is).

Not sure how well it relates to 529, and not entirely sure how it works.
I think it is something along the lines of maxing contributions for the tax deferred growth. Principal is post-tax already. Gains and grant money is taxed to the child (at a lower rate than while I am still working). So taxed less.
Something that just occurred to me is that since the child is taxed, it is income, so am wondering if this is a possible way to increase (his) RRSP contribution room.

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retirebyforty October 23, 2013 at 11:15 pm

20% match is quite nice. That might be a good way to contribute more to RRSP for the kid if it works. Good luck. :)

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Justin @ RootofGood October 23, 2013 at 9:28 am

Like you, I’m a fan of 529’s once you max out your other tax deferred savings plans. We have enough in our 529’s to cover about half the cost of tuition for our 3 kids to attend one of the local excellent state universities. Unfortunately our state tax deduction in North Carolina is going away effective 2014, so the biggest tax incentive to contribute to 529’s is now gone (for us).

Like you mention, we will still enjoy tax free status on withdrawals. Another benefit that I didn’t see in your article (unless I missed it) is the tax free status of any income on your 529 investments each year. For example, if you had $10,000 in a taxable account (~1 years tuition), it might generate $300 or so in dividends each year that would be subject to taxation (in a taxable account). Stick the same $10k in a 529, and you don’t pay tax on it each year. On a larger account balance, that can lead to big tax savings each year as your 529 balance grows.

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retirebyforty October 23, 2013 at 11:16 pm

Sorry to hear about the deduction going away. That sucks.
I’m not very impress with our local state U. We might move to CA for a year before he starts college.

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Kurt @ Money Counselor October 23, 2013 at 9:46 am

Holy cow! Yeah you’ve got to get that 529 going. Then ask all of Jr.’s relatives to, instead of buying him lots of junk he doesn’t need for his birthday and holidays, get him a little something and then make a contribution to his 529!

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retirebyforty October 23, 2013 at 11:17 pm

We deposit all his birthday checks into his 529 account. :)

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payitoff October 23, 2013 at 12:30 pm

can you use 529 for any other options? in case kids decide not to go to school? downpayment for a house maybe?

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Pat October 23, 2013 at 6:11 pm

From what i understand, If your kid decided not to go o school then you will have to pay tax on it.

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retirebyforty October 23, 2013 at 11:18 pm

You can, but you will have to pay 10% penalty and all the back taxes. I haven’t found a way to get around that in my research. You can always transfer it to another beneficiary.

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Pauline @RFIndependence October 23, 2013 at 1:37 pm

It is nice that the penalty doesn’t apply if you get a scholarship, however I am not sure so much college will be needed in 20 years, things are changing fast, with online learning, short careers, even for my generation most people would be better off with two years of trade school and no debt

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retirebyforty October 23, 2013 at 11:20 pm

I still think college is better than no college. It depends on what fields, but I’m a lot better off with my college experience.

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Guest November 26, 2013 at 7:20 pm

I share your concerns. I think the college model is broken (who can come up with hundreds of thousands of dollars in today’s economy?) and a combination of AP credits and online learning will replace college years 1 and 2. Maybe high school will be extended to year 13 and a combination of online and offline classes will be college years 2, 3 and 4. Things are changing faster than people can keep up, so maybe college in 20 years will only be for the top 10% of the population (and not 40%).

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Bryce @ Save and Conquer October 23, 2013 at 4:16 pm

Putting aside $10k for the first five years, and then tapering is a very good plan. That will give compounding a good long time to grow. That’s essentially what we did, although we lump-summed $50k in at the start, and then held off for 5 years. We are only putting in $6k every year now. We already have more than enough in a 529 for our son to go to Cal Poly SLO for 5 years, and UC Berkeley for 4 at their assumed costs in 6 more years. I did not know you could take the money out of a 529 without penalty if the kid has a full scholarship. I will have to look into that. I can use that as incentive for our son to work hard in high school to land a full merit scholarship. (We have a friend who’s son did that at Santa Clara University.) I’d be happy to give our kid the 529 money to use after college if there were no earnings penalty.

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retirebyforty October 23, 2013 at 11:23 pm

Great job! It would be nice to put down $70k now. Maybe if we have a windfall or something like that….
That would be great if your kid can snag a full ride. He can use the 529 for a down payment on a house!

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Steve October 23, 2013 at 4:32 pm

We’re doing something similar for our offspring: front-loading with 5-figure contributions for the first few years of her life.

Also, note that the one-time, 5-year contribution is per gift-er, meaning the max is double for two parents: $140k. That’s more than enough where a wealthy couple could contribute the max in the first year of their child’s life and then just let it sit back and compound.

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retirebyforty October 23, 2013 at 11:24 pm

$140k would be a very nice start. That should be plenty for any colleges (I hope.)

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Pat October 23, 2013 at 6:08 pm

We opened 529 when my son was born. We put 1000 a month ever since. ( He is 6 now) Our plan is with Arizona state which has been working great. my son portfolio is by far the best investment than our own. We will keeping this rate for 3 more years then decide again to let’s it roll or reduce the number.

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retirebyforty October 23, 2013 at 11:26 pm

Congratulation! $1,000/month is a great accomplishment.

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Wilson October 24, 2013 at 8:36 am

You’re right about front-loading; I need to pump up our 529 with a few more deposits to really get it rolling. It blows my mind how much tuition at my alma mater has increased in the 17 years since graduation, easily doubling. With my daughter about to turn 3 at the current rate it’ll be in the 6 figures a year when she’s ready. I just don’t see how the current pace is sustainable. As a percentage of income there will be a huge disparity between the price of tuition versus my father’s salary, versus tuition as a percentage of my future income, earnings, or whatever I’m living off of in 15 years. In retrospect, private school 15 -20 years ago was a great bargain. I’m not too keen on technology as a substitute for college, I think there’s value in moving off, living in a drafty old brick building with strangers, spontaneous late night discussions, and poking around dusty old libraries, and I’d like my daughter to experience that too. I hope something occurs that will keep costs in check, but that’s not really a plan so I guess I’m working through lunch the next month and will make an extra deposit for her Christmas present.

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retirebyforty October 24, 2013 at 11:32 pm

I think going to a 4 year college is a huge plus in anyone’s lives. I’m seeing my college buddies this weekend. The shared experience help you make such good friends. Good luck…

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k8 October 24, 2013 at 10:03 am

I opened my 529 with another state (NV or IA?) in 2001 because my state didn’t have one. We put a lot away the first 3-4 yrs. Then friends and family began to tell me their children were getting full scholarships on their states’ lottery scholarship programs, so I became concerned about growing it too much. 529s have now clarified that you can take the amount of a scholarship back out without the 10% penalty I think.

I started an online brokerage account for my son’s savings reasoning that long term capital gains taxes aren’t that high and there would be more flexibility. It’s been an interesting journey because we let him have some control over it. He now adds his own birthday/Christmas gifts to the savings. A few years ago the salesperson at the Apple store said he was the only 9 yr old to ask how to use the stock market app on an iPod.

In terms of tax shelter, your reader may have been referring to the fact that although the account belongs to the owner, it’s not considered part of their estate for tax purposes. Still seems like the money would eventually have to be used for education to avoid the penalty, but you could pass it on as a 529 after your death to continue to fund education for your heirs.

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retirebyforty October 24, 2013 at 11:34 pm

It’s great that your son got started so early. It will give him a leg up against most people in his generation.
I’d probably pass on the 529 if it’s not used. I’m sure future generations would need it even more.
Thanks for commenting!

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Donny @ Personal Income October 24, 2013 at 10:54 am

I wish that I would have taken advantage of the 529 plan when saving for college instead of having to pay back all of these loans. It is critical for individuals that are starting college to research their options available before taking out college loans.

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payitoff October 24, 2013 at 10:56 am

if you were to leave something for your kid, what would it be? i always ask this to the successful people i know and all of them almost have the same answer, either an invested money in the stock market or savings to put down for a house. im surprised why 529 plan had never mentioned, that’s why i havent really looked into this, since i understand that’s its a very restricted plan.

i asked why money for a house, and they say its the most expensive investment, and they wished they had the money for it instead of working hard to save up when they first bought their house, it will be a good startup for the kids family if parents helped out with buying a home.

makes a lot of sense to me.

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retirebyforty October 24, 2013 at 11:35 pm

Our family’s philosophy is to leave the kid with a good education. It makes such a big difference in how you handle your life. A house is good too, but a higher education is even more important.

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payitoff October 25, 2013 at 1:52 pm

very true.. scholarship might be an option too, but definitely education is a priceless investment, thanks for opening this avenue for me, looking up how to start the 529 now, twins are in PreK so the early the better :D

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Brandon Curtis October 24, 2013 at 12:52 pm

A good article on a good plan. It’s too bad that the 529 landscape is complicated by the fact that every state offers multiple plans, and anyone can use any state’s plan. Several people I’ve worked with were initially scared off by this complexity.

The sites that compare incentives by state are a little helpful, but what people really need is a decision-making flowsheet. I prepared one for choosing a 529 Plan provider: http://www.andhigherstill.com/2013/05/choosing-529-plan.html

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Buy & Hold Blog October 31, 2013 at 7:22 am

Good Post Joe. I took a different tact for creating a college fund for my kids. I’ve outlined it in this blog post.

http://www.buyandholdblog.com/college-529-plan-vs-investing-in-individual-account-reader-question-series/

Summary: I live in Georgia that offers 529 through TIAA-CREF. You can only deduct $2000 at 6% income tax. So, tax savings come about $120. But, to save this $120, we’re stuck with TIAA-CREF funds that charge over 1% in expense ratio and offer actively managed funds and often lag in their performance. Of course, the money would grow tax-deferred, but at some point, we’ll have to pay taxes when we’re in our 50’s, the prime income years.

So, instead of a tax-deferred 529 account, I simply added a Target Retirement Fund that would span for 20 years to my personal individual account. I’m adding money to this fund every week like I’d add to a 529. This also gives us the most flexibility because we can use this pay for non-college expense if emergency arises or if our kids decide to drop out of college to start companies or something drastically changes in the college education landscape or if they decide to pursue their college education abroad.

I don’t know if I’ve made correct judgement or not. But, we’re sticking to this plan. It is one less account to manage.

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Jack @ Enwealthen November 7, 2013 at 2:41 pm

The more I see the government meddling with debt and the money supply, the less likely I am to let my money be held hostage by whatever new legislation they decide to pass in the next 20 years.

While the tax advantages are attractive, I’ll stick to my own investments so I can have the freedom to use the money wherever, however, and whenever I want.

As for the tax-free transfer, my understanding is anyone can gift up to $14K a year tax free to anyone they want, without triggering the gift tax statutes. Having a 529 gives them a way to make sure it goes to the child’s education, but it’s not required for the transfer to be tax-free.

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