529 Investment Options and Strategies
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Table of Contents
What is a 529 Plan?
529 Investment Options
529 Investment Considerations
529 Plan Alternatives
529 Investment Strategies
A Personalized Approach to 529 Plans
A 529 plan offers a tax-advantaged way to save for qualified education expenses. With the right 529 investment options in place, high-net-worth families can start saving for their children’s education from an early age.
However, accurately estimating educational costs and the appropriate amount to invest in a 529 account can be challenging, particularly given the differences between in-state versus out-of-state tuition and the effects of scholarships.
What is a 529 Plan?
A 529 plan is a state-sponsored, tax-advantaged investment account for saving for educational expenses. Earnings on 529 contributions grow tax-free, and withdrawals for qualified education expenses are also tax-free. 529 plan yields can be put toward a variety of educational options, including universities, trade schools, and vocational schools.
There are two main types:
Education Savings Plan: These tax-advantaged accounts function similarly to a Roth 401(k) or IRA, and contributions can be invested into mutual funds or other investments.
Prepaid Tuition Plan: Prepaid plans are generally used for in-state tuition, allowing families to prepay a set amount ahead of time. The Private College 529 Plan works with private schools.
While many view the 529 plan as a set-it-and-forget-it option, often defaulting to target-date funds, financially savvy individuals often take a more nuanced approach.
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529 Investment Options
Portfolio Allocation
Target-date funds are one of the most popular 529 investment options, automatically adjusting asset allocation from aggressive to conservative as the beneficiary nears college age. While convenient, some parents find target-date funds too conservative as their children get older, especially in today’s high-interest-rate environment. For those interested in a more aggressive saving strategy, relying too heavily on target-date funds could limit growth, particularly if the funds move out of equities prematurely.
While target-date funds are popular, some investors prefer more aggressive strategies. For example, a 60/40 split between US and international index funds can offer a balance of growth and diversification. Others opt for an 80/20 stock/bond allocation, especially for younger beneficiaries, to maximize growth potential.
Other high-net-worth individuals prefer a hands-on approach, selecting custom allocations that mirror their broader portfolios.
State 529 Plans vs. Out-of-State Plans
Different states offer different 529 plans, but investors do not have to pick a plan offered by their state of residence. Costs and tax benefits vary between plans, so it might be advantageous to consider out-of-state plans. When picking a plan, families should also research performance to get a sense of what to expect.
Types of 529 Portfolios
Age-based plans and enrollment date portfolios automatically adjust contributions according to the child’s age, typically investing in riskier investments when the child is younger and becoming more conservative as the child nears college age. Static portfolios remain the same unless the investor manually changes the amount.
529 Investment Considerations
Investment Timeline and Risk Tolerance
Families with younger children have over a decade before funds will likely be needed, allowing for a more aggressive approach in the earlier years.
One option is to treat the 529 like any other long-term investment. With this mindset, the 529 has a 15-year timeline with the ability to roll over up to $35,000 into a Roth IRA under SECURE 2.0, offering longer-term tax advantages. For younger children, a growth-oriented approach, potentially favoring index funds or actively managed funds with strong track records, could yield significant benefits.
Some investors treat 529 plans as very long-term investments, potentially holding funds for future generations. This approach allows for a more aggressive investment strategy, focusing on growth-oriented options like index funds or carefully selected actively managed funds with strong track records.
It is wise to stay flexible. For example, a mix of target-date funds and fixed allocation in a 529 account provides exposure to both stocks and bonds, balancing growth with stability.
Overfunding
Overfunding a 529 plan can present challenges; unused funds may face a 10% penalty and income tax on earnings if not spent on qualified education expenses. In some situations, the money spent on penalties and taxes could even exceed the actual college costs.
The SECURE Act 2.0 provides some relief, allowing up to $35,000 to be rolled over from a 529 into a Roth IRA, provided the account is at least 15 years old and other conditions are met. However, this cap leaves families with substantial 529 balances in excess of projected education costs searching for alternatives.
To take advantage of the Roth IRA rollover option, the 529 account must be at least 15 years old and the funds being rolled over must have been in the account for at least five years. The beneficiary must have earned income in the year of the rollover, and the amount rolled over cannot exceed the annual Roth IRA contribution limit. Other strategies to manage overfunding include using excess funds for graduate school or changing beneficiaries to other family members or future grandchildren.
Changing the beneficiary is another useful tool, allowing families to repurpose unused funds for other children, grandchildren, or even themselves for further education. This flexibility reduces the risk of locking too much money into a 529 account.
Tax Considerations
529 plans offer tax benefits at both the state and federal levels, but state-specific tax benefits can significantly influence contribution strategies. For example, Virginia allows a $4,000 per account deduction on state income tax returns. However, some states, like California, don't offer state tax deductions for 529 contributions.
Additionally, while earnings are tax-free when used for qualified expenses, withdrawing funds for non-qualified expenses incurs penalties. The golden ticket is estimating college expenses as accurately as possible and only investing that much in a 529—but this is, of course, easier said than done. Tuition costs vary widely between universities depending on whether they are private vs. public and in-state vs. out-of-state.
For families anticipating scholarships, a little-known provision allows penalty-free withdrawals equal to the amount of scholarships received. However, these withdrawals are still subject to income tax on the earnings portion.
529 Plan Alternatives
For families wary of overfunding their 529 plans, alternative savings vehicles like taxable brokerage accounts or U.S. Treasury bonds can offer additional flexibility without the restrictions of a 529 plan.
In addition, the SECURE Act 2.0 grants the ability to roll over up to $35,000 from a 529 plan into a Roth IRA for the beneficiary. This change addresses one of the primary concerns with 529 accounts: overfunding. The rollover provision allows some of the excess to be repurposed for retirement savings, though the relatively low cap means that large balances could still face taxation or penalties.
To take advantage of this option, the 529 account must be at least 15 years old, and the funds being rolled over must have been in the account for at least five years. Additionally, the beneficiary must have earned income in the year of the rollover, and the amount rolled over cannot exceed the annual Roth IRA contribution limit.
This provision offers families a safety net, providing a tax-efficient way to move funds out of a 529 without facing penalties. For some families, this is enough reassurance to continue contributing to 529 accounts without fear of overfunding.
For those seeking additional flexibility or stability, especially as the beneficiary nears college age, U.S. Treasury bonds can be an attractive option. In the current high-yield environment, bonds offering 5%+ returns can provide a stable complement to more aggressive 529 investments. However, be sure to consider the tax implications of bond interest income.
529 Investment Strategies
There are a lot of elements to consider for families determining the right 529 investment strategy. Here are some quick tips to maximize returns while minimizing risk:
Invest Early: Opening a 529 account as soon as possible allows for the most time to accumulate savings. Even if contributions are minimal when the child is young, simply getting started will give interest time to compound, and contributions might be able to be increased later on.
Determine Contribution Amounts: For many plans, there is no minimum contribution amount. Others have low minimums, such as $25 monthly. There are no maximum 529 investment limits, but contributions over the annual gift tax exclusion work against one’s lifetime estate and gift tax exemption. Investors can also set up automatic contributions for convenience and peace of mind.
Know What Counts as a Qualified Expense: Withdrawals from a 529 can only be used for qualified education expenses and must take place the same year as the expense occurred. The definition of a qualified expense varies according to state but generally includes expenses such as tuition, books for school, housing, and computers.
Ask for Gifts: Friends and family looking to give a child a gift can contribute to their 529 account. There are various platforms that make it easy to ask for contributions to a 529 account online.
Regularly Review and Adjust: As a child ages and market conditions change, parents should regularly review their 529 investment allocations. Consider shifting to a more conservative mix as college approaches, but be cautious not to become too conservative too early, potentially missing out on growth opportunities.
Consider a Mixed Approach: Some investors find success in combining target-date funds with fixed allocation investments. This strategy provides both the automatic rebalancing of target-date funds and the potential for higher growth from more aggressive allocations.
For high-net-worth families, there are additional strategies to consider that can maximize the benefits of 529 plans. Here are some advanced techniques to potentially enhance your education savings:
Front-Load Contributions: Some families choose to make large, upfront contributions (e.g., $150,000 per child at birth) to maximize tax-free growth potential over the longest possible timeframe.
Use Strategic Withdrawals: Families can leverage 529 withdrawals as a way to move funds tax-free from education savings to taxable accounts. This involves paying tuition costs from the 529 while simultaneously shifting investments between tax regimes.
Consider Housing Options: In certain situations, 529 funds can be used to pay for housing owned by the beneficiary during college. However, this strategy has specific limitations and tax implications, so it is best to consult with a tax professional before implementing.
A Personalized Approach to 529 Plans
The right 529 investment option depends on several factors: the child’s age, the family’s overall financial situation, and preferences for risk and flexibility. While target-date funds remain a popular choice, especially for those seeking a hands-off approach, they may be too conservative for some, especially in low-interest-rate environments. For those seeking more control, index funds or customized portfolios offer greater flexibility and potentially higher returns.
Regardless of the specific investment choices, regularly review the 529 account to ensure it aligns with educational costs and family goals. The SECURE Act 2.0 can help alleviate concerns about overfunding, but it is crucial to stay informed and adapt strategies as laws and circumstances change.
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