The 529 Plan: A Smart Alternative to College Loan Debt

One in three American students borrow money in pursuit of a college degree. The average student's loan debt soared to a record high of about $41,000 in 2021 – collectively that's about $1.75 trillion. Since it's close to 5/29, let's talk 529s - a shining alternative to college loans. Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Mounting Debt

According to the College Board, since the early 1990s the cost of attending a public institution of higher learning has doubled. And the cost to attend a private college institution is triple the cost of attending a public school. Because some many folks aren't able to tackle these ever-increasing costs through personal savings and investments, student loan debt load will probably continue to grow.

Many who have financed their own education – and those who chose to join the workforce out of high school – are not big fans of government loan “forgiveness.” Prospective students and their families, in fairness, have all the more reason to seek something other than government loans. But will they? (My personal reason for objecting to “debt forgiveness” is the risk of moral hazard – whereby future borrowers incur ever higher student debt anticipating that “forgiveness” by politicians will be ongoing.)

With that said, there is a feasible alternative to student loans that won't drain savings accounts - you just have to start early.

The 529 Option

The most popular tax-advantaged college savings plan these days is the 529 plan, or 529 Qualified Tuition Program. 529 Plans are operated by state or educational institutions with certain tax and other advantages to ease the burden of saving for college and other post-secondary training. Likewise, they can be used to pay for tuition at elementary or secondary public, private, or religious schools for the designated beneficiary.

There are no annual contribution limits. Earnings are not subject to federal tax and typically not subject to state tax when used for qualified education expenses such as tuition, fees, and books, as well as room and board at eligible education institutions; and tuition at elementary or secondary schools. Note: Although contributions to 529 Plans are not deductible, they offer tax-deferred growth and tax-free withdrawals. You won't pay any income taxes on the amount your account earns while it's growing, and if you use the money for qualified education expenses, those earnings will be tax-free when you withdraw them.

The 529 plan has rivals, but outperforms them in my opinion.

529 Vs. Coverdell ESA

The Coverdell Education Savings Account (ESA) is a more limited but tax-favored alternative to the 529. However, it has a more restrictive $2,000 annual contribution limit for a particular child. If that limit is exceeded, the plan beneficiary will owe a 6% excise tax every year on that excess.

Investors filing joint returns are further discouraged from setting up an ESA if their modified adjusted gross income (MAGI) is greater than $190,000 ($95,000 for single filers). Specifically, the $2,000 annual maximum is phased out for joint filers with MAGIs falling between $190,000 and $220,000. Such monetary limitations represent downsides to many… and in addition, ESAs are age-limited. How so? Contributions to a Coverdell plan must end when the beneficiary turns 18, and withdrawals for qualified expenses must be distributed by the time a beneficiary turns 30. These limitations are particularly discouraging to investors with large incomes. On the other hand, these same limits appeal to prospective benefactors with lessor resources.

529 Vs. UTMA

IMHO 529s are also superior to the Uniform Transfers to Minors Act (UTMA), which allows an adult to transfer assets to a minor by opening a custodial account managed by the adult who controls the assets until the minor reaches a certain age, usually 18 or 21. There are no limits on the dollar amount of gifts or transfers that can be made to a UTMA, but contributions above $16,000 per year ($32,000 for a married couple filing jointly) will incur federal gift tax. Also, once gifts or transfers are made to an account, they cannot be revoked.

An upside: UTMAs are commonly used to save for college, but there is no penalty if UTMA assets aren't used to pay for college. Contributions can be invested in typical securities, like stocks, bonds, mutual funds, ETFs and real estate property, as well as other assets. UTMAs have no taxes on withdrawals since contributions are made with after-tax dollars but there could be taxes on unearned income (including taxable interest, dividends, and capital gains). A 529 is not as flexible as a UTMA or other taxable accounts in this sense, but they offer valued protection from taxes as the account grows and to those tax-free withdrawals for educational purposes.

529 Vs. I Bonds

529 plans provide the same federal tax treatment as my beloved U.S. Treasury-issued Series I Savings Bonds - I Bonds - but with greater contribution flexibility.

Individuals can contribute as much as they like to a 529 plan each year, provided they don’t exceed the maximum balance limit set by the state where the plan is registered. There is a maximum contribution limit for each beneficiary up to the total balance limit allowed by that state - it ranges from $235,000 to $529,000. And of note, 529 plan contributions are treated by the IRS as gifts and may be subject to taxation when totaling more than $16,000 in a year or $80,000 over five years.

If a couple is able to max out their annual 529 contributions, it’s likely that those same couples will not have a low enough income to qualify for the I Bond tax break. The I Bond interest exclusion phases out for 2022 income (MAGI) is between $85,800 and $100,800 for single filers and between $128,650 and $158,650 for taxpayers who file as married filing jointly.

Now for some particulars on my preferred 529.

The Vanguard Way

Credit for information in this section belongs to Vanguard, which has a unique and clarifying approach to discussing what it calls the “surprising benefits” of 529 plans. According to Vanguard, those benefits include:

Whether a high school graduate plans to study abroad, attend a traditional university, or a trade school, a 529 plan can help fund the training. And some 529 plans allow for funds to be used for K–12 tuition and fees of up to $10,000 per student per year at a public, private or religious school (Note: state tax treatment of K–12 withdrawals and apprenticeship program expenses is determined by the state where the taxpayer files state income tax).
529 plans pay for more than tuition. Plan funds can also be used to pay for room and board, books, supplies, and other qualified expenses at any accredited vocational school, college, or graduate school in the U.S. or abroad.
The account beneficiary can be changed at any time as long as the new beneficiary is a qualified family member (i.e., if the initial beneficiary decides not to go to college, the plan’s funds can go to a sibling, stepchild, parent, or another family member who plans to attend a qualifying institution).
Almost anyone can open a 529 plan, including grandparents, other relatives, and friends…even you.
If an individual plans to enroll in school, open a 529 account. That’s right, the account owner and beneficiary can be the same person. And up to $10,000 from a 529 plan can also be used for student loan repayment (Note: state tax treatment of student loan repayments is determined by the state where the taxpayer files state income tax).
After opening a 529 account, anyone can contribute – friends, family, neighbors – via cash, check, or electronic transfer. More specifically, regarding Vanguard’s 529 College Savings Plan, family and friends can use Ugift® to contribute online.
Remind Grandpa that more than one account can be opened on behalf of the same beneficiary (i.e., if a parent has already opened a 529 plan for a child, that child’s grandparent can open one, too. After doing so, they’re both saving for future education expenses and are still eligible for state tax deductions).
Specifically regarding a Vanguard 529 account, once open, it can be styled to “set it and forget it” with automatic, recurring contributions. Vanguard requires a monthly minimum contribution of $50 – which is probably less than what many folks spend on streaming services (recall those million dollar habits). But don’t forget to monitor 529 asset allocations to ensure alignment with overall allocation goals.
Does an account owner wish to leave 529 plan investments to the experts or DIY? The Vanguard 529 College Savings Plan has options to best suit how individuals approach investing. Hands-on investors can strategize and choose an asset mix that fits their timeline and risk tolerance, but if DIY is not their style, owners can choose a Target Enrollment Portfolio instead, which automatically adjusts to become more conservative as beneficiary(s) approaches their enrollment date.

Start Early

The key to avoiding burdensome education debt, much like planning for retirement, is to start saving (and investing) early and routinely…sound familiar? Millions of students escape the clutches of higher education institutions with little or no debt. Some are fortunate to come from families that provide financial help. Others do it the more challenging way, earning scholarships and grants through academic achievement or by working long hours while in training. Still, planning ahead and investing in a good program like a 529 plan is the key.

In Sum

There are important tax advantages to saving money for educational purposes using a 529 plan. No income tax will be due on the plan’s earnings as long as the money remains in the account. And if the money is withdrawn to pay for qualified education expenses, those earnings withdrawals will be free of federal income tax—and, in many cases, free of state tax, too. Try it and enjoy the reduced stress of having no education debt upon graduation!