529s and Free Money

by John Cooney on Nov 27, 2020

529 Plans, personal finance, fee-only financial planner

One of the most often asked questions I receive as a Financial Planner is from parents asking about saving for their Children’s educations.  My advice is often to start early and use a 529 plan.  Now, for Massachusetts residents, I have even another reason to preach starting early and using a 529 plan; free money!

What Are 529 Plans?

529 plans are Education Savings Accounts (ESAs), that offer tax benefits for owners of the account to incentivize them to save for future education costs.  The primary tax benefit to 529 accounts are that the money contributed will grow tax-free and can be withdrawn tax-free as well, provided it is used to pay for qualified education expenses.  That is an important qualification as you will need to include as income and pay an IRS penalty if you use the money on a non-qualified expense.  Let’s look at an example to see how this works:

Bob and Marie have a 2-year-old son, John.  They set-up a regular savings account at the local bank with the goal of using this account to help pay for John’s college in 16 years.  They made an initial deposit of $10,000 to the account, which has grown to $20,000 by the time John turns 18.  Every year, the account earned interest and Bob and Marie report that interest as income on their tax return, which means over the course of the 16 years, they have included an additional $10,000 in income on their taxes.  If they were in the 22% tax bracket for those 16 years, that could amount to an additional $2,200 in taxes paid.

Joe and Mary have a 2-year-old son, Tommy.  They set-up a 529 ESA for Tommy and made an initial $10,000 deposit into the account, which grew into $20,000 by the time Tommy was 18.  Joe and Mary did not pay any taxes on the additional $10,000 in growth and as long as they use it for Tommy’s qualified education expenses, they will not pay any taxes when they withdraw the funds either.  Since they too were in the 22% tax bracket for all 16 years, this saved them $2,200 in taxes!

Another tax benefit to the 529s is at the state level.  Many states have their own 529 plans, which can be used for in-state or out-of-state schools.  If you are a resident of that state and contribute to the state’s 529, you are often allowed to deduct some or all of your contributions from your taxable income, which can reduce your tax liability even more.  For example, in Massachusetts, you can deduct up to $1,000 if you are a single filer and $2,000 for those filing jointly as married.

What About This Free Money?

This portion comes with a couple of caveats; first, it only applies to Massachusetts residents and secondly, only to those residents who had a baby or adopted a child after January 1st, 2020.  This is where Baby Steps comes in.  Massachusetts established a seeding program to help promote saving for education.  Every baby born or child adopted after January 1st, 2020 and who opens a Massachusetts U.Fund account within one year of the birth/adoption will receive a $50 deposit into the account.  Is that a ton of money that will allow you to pay for your child’s education?  No, it isn’t, and it isn’t designed to do so.  It is to encourage the opening of an ESA early, and to reward those parents who do, so why turn it down?

How to Receive the $50

  • Determine You Are Eligible
    • Must Be a Massachusetts Resident
    • Baby Must Have Been Born/Adopted After January 1st, 2020
    • Child Must Be Names as Beneficiary of Account Within 1 Year of Birth/Adoption
  • Open a U.Fund Account
    • This is a Fidelity Managed Account
    • Make Sure You Are Comfortable with the Investment Choices
    • Talk to A Financial Advisor If You Have Questions
  • Verify You Received the $50 Contribution
    • Deposits Should Show in the Account Within 60 days of Opening
  • Regularly Contribute to the 529 (Optional, but highly, highly recommended!)

With education costs increasing, a 529 can be a useful tool in reducing the financial burden on you and your children and also reducing the stress around these costs.  An additional benefit came with the Tax Cuts and Jobs Act, which passed in 2017.  This law made a change that allowed 529 accounts to be used not just for college, but for expenses for those in K-12 as well.  A 529 plan can be a great component of your overall financial plan, and when started early, along with regular contributions, can go a long way towards meeting the financial demands of education.  Adding the Baby Steps Saving Plan for Massachusetts residents makes this even more of a must for any new parents in the Commonwealth.

How Can a 529 fit in your Financial Plan?

Contact Us Now