Why 529 Plans Make Great Gifts for Kids (and Parents)

When I was growing up, I remember receiving an envelope from my grandparents every year on my birthday.  Inside was a fancy looking piece of paper with my name and a dollar amount.  It was a savings bond that my parents would take and keep in a locked box for safekeeping.

Of course, I’d receive the typical gifts of toys and clothes, so I never really appreciated the gift of money that I couldn’t even redeem for years to come.  When I got older, I finally was able to cash in some of my bonds to purchase my first car!

EE savings bonds, like the ones I received, are typically purchased for half their face value.  In 20 years, the bond will mature and can be sold for their face value.  For example, a $50 savings bond would be purchased for $25 and in 20 years would be worth $50.  The growth rate is so low, you’d be better off putting your money into a savings account with today’s rates!

After my wife and I welcomed our first child in September, my parents said they wanted to do something similar for our son on his birthday but were open to an investment that made a little more sense in the long-term.

My first thought…a 529 Plan!

What is a 529 Plan?

In simple terms, a 529 Plan is a special type of savings account that is to be used for education expenses.  The IRS has established tax advantages for money in this account in Section 529 of the Internal Revenue Code, thus the name.  It’s similar to a 401(k) Plan for retirement, except a 529 Plan is designed for education savings.

The money you earn in a 529 Plan will be exempt from federal income taxes which makes this a great way to save on taxes as money is set aside for education.

Depending on your state and who owns the 529 Plan, you may be able to take some state tax deductions for your contributions, but otherwise, contributions to a 529 Plan are not deductible on your state taxes. 

529 Plans – A Great Gift for Kids (and Parents)

Now that you understand a little bit more about what a 529 Plan is, let me explain why this can be a great gift for kids.

Just like savings bonds, contributions to a 529 Plan are not the most exciting gifts for kids; however, these gifts provide an excellent opportunity to build an education savings fund for a child.

Not only is this a gift that can help eliminate the child’s need for student debt, it’s also a gift for the parents.  Many of us want to give our children better opportunities than we had growing up.  Unfortunately, within this generation of new parents, the vast majority of Millennials have little to nothing saved for their own retirement, let alone education goals for their children.

The funds in a 529 Plan may grow enough over the child’s younger years to open up additional opportunities for schooling that may not have been afforded without enough savings.

Remember, the sooner you start saving money away, the more time it will have to grow!

529 Plan Benefits

As I mentioned before, a 529 Plan has certain tax advantages.  The main tax benefit from a 529 Plan is that the earnings in the account are free from federal income tax when used for qualified education savings.

Some states will allow state income tax deduction, but usually only if you use your state’s 529 Plan and you are also the owner.  So, if a grandparent makes a contribution to a 529 Plan owned by the parent, they most likely will not be able to take advantage of a state tax deduction.

Although 529 Plans were designed for higher education expenses, recent changes to the tax law have also allowed 529 Plan funds to be used for private K-12 expenses as well.

There are also some important logistical benefits to a 529 Plan that aren’t found in other types of savings accounts.

When a 529 Plan is created, it is owned by someone other than the child.  The child is instead named as the beneficiary of the account.   This means that the owner of the 529 Plan has control over the funds, even after the child turns 18.  In other types of accounts, the control of the funds is usually transferred into the child’s name when they turn 18 or 21.

By maintaining control of the funds in a 529 account, the owner can ensure the money is only used for education expenses.   The owner is also able to change the beneficiary of the account.

Let’s say Child 1 doesn’t use all of the funds in the 529 account, or they dropped out of college, or decided not to go at all!  The 529 owner can change the beneficiary to Child 2, without penalty, to fund any of their education expenses.  The owner can even change the beneficiary to themselves if they have no other children.

Despite the benefits, the 529 Plan is not without risk.  In the worst-case scenario, the funds in a 529 account are not used at all and are withdrawn by the owner.  In the case where funds are not being used for qualified education expenses, income tax would be due on the earnings along with a 10% penalty.

The 529 funds are also typically invested in the stock market which means it could lose value.  If your child is close to starting their education, or you want to avoid all risk, a 529 Plan may not be your best option.

Be sure to talk to a financial professional about your specific situation if you are weighing your options!

Important Considerations for Student Aid

When it comes time for college, everyone is encouraged to submit the FAFSA form which is a free application for federal student aid.  The application process takes into consideration what assets the student has and what assets the parents have.  Any assets in the student’s name carry a heavier weight than assets in the parents’ name which means the more money the student has, the more their financial aid will be reduced.   Keeping college savings funds in a 529 account owned by the parents or a dependent student will count towards the parents’ assets.

If a grandparent, aunt, uncle, or any other non-parent owns the 529 account, the distributions from this account will count as income for the student on the FAFSA.  This will significantly reduce the student’s aid eligibility!

Final Thoughts

While 529 Plan accounts may not offer as much investment flexibility as other types of savings accounts, and may incur penalties if funds are not used for education, they are one of the best vehicles for education savings available today.

The ability for other family members to make contributions to this account makes it a great gift option for anyone wanting to make a positive investment in a child’s future.  Not only could this help open additional doors for a child, it also reduces the need for student debt on both the child and the parents.

If you have questions on how to open a 529 account or how to best plan for your child’s education goals, feel free to reach out to me with an email or free consultation!