529 Plans vs. Brokerage Accounts for College Savings

Saving for college is a daunting task.

It’s hard enough to find room in your budget for contributions on top of your other financial responsibilities, and when you combine that with the fact that college tuition has been steadily rising over the past 30 years, it might feel like sending your child to college is an impossible goal.

And while you shouldn’t stress too much about saving for college, you can at least try to get the most out of every dollar you do save. And one of the easiest ways to do that is simply making sure that you’re using the right type of investment account.

We’ve previously broken down the 529 plan vs. Roth IRA comparison, and today we’re going to compare the 529 plan to a regular brokerage account.

Both have pros and cons, so let’s get into it!

The Basics of a 529 Plan for College Savings

You can click here for a detailed breakdown of 529 plans, but essentially they work a lot like Roth IRAs, just for education instead of retirement:

There is no federal income tax deduction for contributions, though some states offer a state income tax deduction.
Your money grows tax-free while inside the 529 savings account.
You can withdraw the money tax-free for qualified education expenses, which as of 2018 includes tuition for private K-12 education as well as college expenses.

The main downside is that if you don’t use the money for qualified education expenses, your earnings are both taxed as ordinary income and subject to a 10% penalty upon withdrawal. There are exceptions for scholarships, and you are allowed to change the beneficiary and use the money for another family member, but there’s still some risk involved.

The Basics of a Brokerage Account for College Savings

A brokerage account is simply a regular investment account that comes without any special tax breaks. What it does offer is a lot more flexibility than a 529 plan:

You can contribute as much as you want (529 plan contribution limits are much higher than most people will ever need, but they’re not quite unlimited).
You can invest in just about whatever you want.
Most importantly, you can withdraw as much money as you want at any time and for any reason. You won’t be penalized and your earnings will often be taxed at lower capital gains rates.

Put simply, brokerage accounts offer more flexibility than 529 plans, with the trade-off being a lack of tax breaks if the money is used for education.

How Much Are Those 529 Plan Tax Breaks Worth?

So how much are those tax breaks worth? And how much money might those extra taxes and penalties cost you if you need that 529 money for something other than education?

A lot depends on contribution amounts, timeline, and tax rates, but here’s how it breaks down if you contribute $100 per month from the time your child is born until the time he or she reaches age 18*:

If the money is used for education, you’ll have $34,534 available in the 529 plan and $31,700 in the brokerage account. That’s a difference of $2,834 in favor of the 529 plan.
If the money is not used for education, you’ll still have $31,700 available in the brokerage account, but you’ll only have $30,427 available in the 529 plan. That’s a difference of $1,273 in favor of the brokerage account.

In other words, the upside of a 529 plan is an extra $2,834 if you use it for education. The downside is a loss of $1,273 if you don’t.

Again, the exact numbers will depend on a lot of variables. This is fairly simple example, but it helps to illustrate the scale of the difference.

*Here are some of the other assumptions I made to run the numbers:

You invest 60% of your college savings in stocks and 40% in bonds.
Stocks return 6% annually. 4% of that is from capital gains that are deferred until withdrawal. 2% is from qualified dividends that are taxed annually at 15%.
Bonds return 2% annually and are taxed as ordinary income as earned.
Marginal tax rate is 25%.

How to Choose Between a 529 Plan and a Brokerage Account

Here are a few additional factors to consider as you try to decide whether you’re better off using a 529 plan or a brokerage account for your college savings:

The biggest factor is what you plan to use the money for. If you’re 100% sure that the money you’re saving will be used for education, a 529 plan is likely to be the better route simply because of the tax breaks. If you’re not sure, you might be better off using a brokerage account or striking a balance between the two.
In general, the more you can contribute and the earlier you start contributing, the more a 529 plan’s tax breaks will benefit you.
Those tax breaks are also more valuable if you’re in a higher tax bracket, and especially if you live in a high-tax state that allows you to deduct 529 plan contributions.
529 plans are more valuable if your child is likely to attend K-12 private school at some point, since you’ll have more opportunities to use the money tax- and penalty-free.
If you’re not already on track for retirement, with an emergency fund in place and high-interest debts paid off, then it’s probably best to prioritize those goals before contributing to a 529 plan.

At the end of the day, it’s a decision between upside and flexibility that needs to be made within the context of your personal goals and overall financial situation. Both are great accounts, and in many cases it can be smart to strike a balance between the two.

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.

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